Choices for Efficient Private Infrastructure Provision in East Asia

Choices for Efﬁcient Private Infrastructure Provision in East Asia

Edited by Harinder Kohli, Ashoka Mody, and Michael Walton

The World Bank Washington, D.C.

Contents

1 Making the Next Big Leap: Systemic Reform for Private Infrastructure in East Asia 1 Harinder Kohli, Ashoka Mody, and Michael Walton

2 Organizing the Government for EfÞcient Private Participation in Infrastructure: Lessons from Australia 21 Donald Russell

3 Contracting for Private Provision of Infrastructure: The Malaysian Experience 43 Yahya Yaacob and G. Naidu

4 Regulating Private Involvement in Infrastructure: The Chilean Experience 55 Alejandro Jadresic

5 Managing Environmental and Resettlement Risks and Opportunities in East Asian Infrastructure 71 Bradford S. Gentry

6 Financing Private Infrastructure: Lessons from India 81 Montek S. Ahluwalia

iii

1 Making the Next Big Leap: Systemic Reform for Private Infrastructure in East Asia Harinder Kohli, Ashoka Mody, and Michael Walton

uch is expected of private Þnancing to support. Recognizing the limits to private help meet the infrastructure require- involvement under the incremental approach, Mments of the rapidly growing East some countries are undertaking broader policy Asian economies. In the Þrst half of the 1990s and institutional reforms aimed at creating an private Þnancing did grow briskly. East Asia led environment more conducive to private partici- the developing world in total international pation, but these efforts are still at an early stage. Þnance for infrastructure, and a sharply grow- Designing such reforms, improving methods of ing share of that Þnance went to private projects contracting with private parties, building regu- (Þgures 1.1 and 1.2). In 1996, $13 billion in inter- latory capacity, and developing domestic capital national capital ßowed to East Asian infrastruc- markets remain on the policy agenda in all the ture projects, more than $9 billion of it for regionÕs economies. private activities. Domestic sources provided an The chapters in this monograph illustrate the estimated $3 billion for private infrastructure. policy concerns and choices in moving toward Despite the growth in private investment, it efÞcient private involvement in infrastructure. remains a small share of all infrastructure invest- Choices arise in the strategy and organization of ment in East Asia, between 12 and 18 percent reformÑwith regard to sector, the extent of pri- (although there is much variation in this share vate participation, the speed of reform, and the across the region). And because much of this planning and coordinating roles of the govern- investment is backed by implicit or explicit gov- ment. Choices must also be made in the meth- ernment assurances, the share of private capital ods for contracting and regulation, the at risk is far smaller. Moreover, the growth of pri- management of environmental and resettlement vate Þnancing slowed in 1996, partly because of issues, and the development of Þnancing mech- the lumpiness typical of infrastructure invest- anisms to increase access to long-term funds. ments. This monograph draws on experience in The chapters draw on experience in a range of a number of countriesÑin East Asia and else- countriesÑAustralia, Chile, and India as well as whereÑto analyze the impediments to and economies in East AsiaÑto show what choices prospects for private Þnancing of infrastructure. are available and what strategies governments The challenges in achieving substantial pri- have followed. Experiences from outside East vate risk-taking are many. Most East Asian Asia illustrate the payoffs of a more integrated economies have adopted an incremental and concerted move toward private provision of approach to private participation in infrastruc- infrastructure. ture. They have sought private investment The chapters were originally prepared as mainly for speciÞc projects, ring-fenced to insu- background papers for a high-level conference late them from the existing structure of delivery. on private involvement in infrastructure, spon- The result has been variable ßows of investment, sored by the World Bank and the government of typically backed by substantial government Indonesia and held in Jakarta, Indonesia, in

1 2 Choices for EfÞcient Private Infrastructure Provision in East Asia

Figure 1 East Asia leads the developing world Figure 2 . . . and devotes a growing share of it in international finance for infrastructure . . . to private projects Infrastructure financing raised by developing countries, International infrastructure financing raised in East Asia, by type 1986–96 (US$ millions) of borrower, 1986–96 (US$ millions)

15,000 10,000 East Asia and the Pacific Private Latin America and the Caribbean Europe and Central Asia 12,000 South Asia 8,000 Middle East and North Africa Sub-Saharan Africa 9,000 6,000 Public

6,000 4,000

3,000 2,000

0 0 1986 1988 1990 1992 1994 1996 1986 1988 1990 1992 1994 1996 Source: World Bank 1997a. Source: World Bank 1997a.

September 1996. Ministers from East Asian gov- lion). Indeed, in 1996 the ßows to public projects ernments and senior private sector representa- fell sharply, from about $5 billion to just over $3 tives gathered for two days to identify and billion. discuss the major stumbling blocks to broader A distinguishing feature of private capital and more effective private participation in infra- ßows to East Asia is the large share going to new structure. projects rather than to Þnance the transfer of This overview chapter describes the recent assets in privatizations. Between 1984 and 1996 trends in international Þnancing of infrastruc- the number of privatization transactions in Latin ture projects in East Asia, discusses the key pol- America was about the same as the number of icy and institutional impediments to greater new investment transactions; in East Asia, by private participation, and assesses the role of contrast, there were only a third as many priva- domestic capital markets and Þnance. It then out- tization transactions as new investment transac- lines a national and regional strategy for stimu- tions (World Bank, Private Sector Development lating private investment in infrastructure. Department, Private Infrastructure Project Database). Privatization drew 20 percent of the Trends in international Þnancing for Þnancial ßows for infrastructure into East Asia infrastructure in 1993, 35 percent in 1994, and less than 10 percent ($800 million of $8.7 billion) in 1995 (World East AsiaÕs appetite for infrastructure Þnance is Bank, International Economics Department, evident in the numbers.1 In 1996 East Asian Privatization Database). economies received $12.7 billion for infrastructure through equity, loan syndications, and Who is receiving the investment? bond issues, absorbing just under half of the $27.4 billion in infrastructure Þnance received No single country in East Asia has dominated in by all developing countries.2 Three-quarters of international Þnance for private infrastructure the international ßows to East AsiaÑ$9.3 bil- projects. In 1995 and 1996 Indonesia was the lionÑwent to private projects. In the rest of the largest recipient, however, receiving almost $4 developing world too the private sectorÕs share billion in each of these yearsÑ40 percent of all in international capital ßows for infrastructure ßows to private infrastructure projects in the increased steadily over the 1990s, from about a region (table 1.1). Private capital for infrastruc- third in 1991 to three-quarters in 1996 ($11 bil- ture accounted for about a third of all private Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 3

Table 1.1 International ﬁnance for private infrastructure in selected East Asian economies, 1986–96 Country 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 China 0 0 0 0 0 0 761 145 212 185 904 Indonesia 0 0 34 0 0 0 339 0 161 3,690 3,809 Korea, Rep. of 75 160 12 0 957 285 330 105 374 772 1,164 Lao PDR 0 0 0 0 0 0 0 0 0 0 20 Macao 0 0 0 0 0 0 0 0 246 0 0 Malaysia 10 0 42 767 266 31 240 1,135 3,714 1,074 703 Philippines 0 0 0 0 23 39 336 707 1,044 2,135 1,072 Thailand 0 0 0 0 291 0 20 3,619 1,015 936 1,622 Vietnam 0 0 0 0 0 0 0 0 0 5 12 Total 85 160 88 767 1,537 355 2,026 5,711 6,766 8,797 9,306

Source: Euromoney; Loanware; Bondware; World Bank staff estimates.

ßows into Indonesia in 1995 and a fourth in 1996. China may be the dominant user of interna- Before 1995, however, the largest annual capital tional capital ßows for infrastructure in the com- inßow for private infrastructure into Indonesia ing years. Inßows into China jumped to $900 was $339 million, in 1992. The huge jump in 1995 million in 1996 with increasing activity in power and 1996 reßects primarily the Þnancing of a few and transport. Although private investment in large independent power projects whose nego- infrastructure remains well below projections, tiations, under way for many years, had Þnally both the government and the private sector have been completed. In addition, the partial privati- taken actions likely to boost it. The government zation of the telecommunications authority has prepared a model for build-operate-transfer drew in equity ßows, and the award of telecom- projects and applied it to the Laiban power pro- munications concessions at about the same time ject. The private sector has recently raised funds created demand for Þnancing to meet the invest- by securitizing existing projects and then issuing ment obligations under the contracts. shares on the Hong Kong (China) and Shenzhen Nor does any other economy in East Asia stock exchanges. This Þnancing strategy marks show a clear, strong trend (Þgure 1.3). Perhaps a shift from pure project ÞnanceÑwhere Þnanc- the most consistent growth has been in the ing is based only on project cash ßows and rev- Philippines, however. From virtually none in enuesÑto a corporate Þnance, or pooled, 1991, private investment in infrastructure in the structure, which generally gives greater comfort Philippines grew rapidly until 1995, when inter- to lenders. national capital ßows for infrastructure were just over $2 billion. But in 1996 the ßows fell to $1 billion. The fast growth was due to the private Figure 3 International financial flows to private power program for installation of more than infrastructure as a percentage of GDP, 1986–96 3,000 megawatts of power. Now that the pro- Percent gramÕs objectives have been substantially met, 6 Malaysia the investments in private power generation are Philippines Indonesia tapering off. But demand for private infrastruc- 5 Thailand ture Þnance in the Philippines has been sus- Korea, Rep. of China tained by deregulation in telecommunications 4 allowing entry by new providers. Other countries show a choppy pattern. In 3 Malaysia international ßows rose from a small amount in 1991 to $3.7 billion in 1994, then 2 declined in 1995 and 1996. Thailand had a peak 1 inßow of $3.6 billion in 1993 but has had much smaller ßows since then. But both countries, par- 0 ticularly Malaysia, have had signiÞcant domes- 1986 1988 1990 1992 1994 1996 tic Þnancing. Source: World Bank 1997a and 1997b. 4 Choices for EfÞcient Private Infrastructure Provision in East Asia

Figure 4 Loans have been the main source The changing instruments of international finance for private infrastructure in East Asia The mix of Þnancing instruments in East Asia dif- Percent fers from that in Latin America, reßecting the dif- 8,000 ferences in the sectoral pattern of demand for 7,000 Þnancing. Following the privatization of assets, Loans Latin American infrastructure enterprises have 6,000 turned to bond and equity markets for most of 5,000 their international Þnancing. In East Asia there has been a signiÞcant rise in international bond 4,000 and equity Þnance, but syndicated loans have 3,000 been the main source of Þnance, accounting for Bonds 2,000 more than half in 1996 and an even larger share in 1995 (Þgure 1.4). This is explained largely by 1,000 Equity private power projects, which have relied mostly 0 on syndicated loans, with debt-to-equity ratios in 1986 1988 1990 1992 1994 1996 the range of 75 to 25. In East Asia telecommuni- Source: World Bank 1997a. cations Þnancing, like Þnancing for private power, has followed the limited recourse model Sectoral shifts (in which repayments are based largely on the projectÕs ability to reÞnance the debt). The The capital ßows for private infrastructure in telecommunications sector has relied more on East Asia have clearly been driven by indepen- bond and equity issues than has the power sector, dent power generation and telecommunications. but syndicated loans have also been important. While in Latin America telecommunications has taken a decisive lead, in East Asia neither sector Policies and institutions for private has dominated. Power took the lead in 1992, but infrastructure was overtaken by telecommunications after a substantial investment in Thailand in 1993, and The review of international Þnance for private since then the two sectors have traded the lead a infrastructure in East Asia shows that the ßows few times. are signiÞcant relative both to public ßows and Despite some privatization of telecommuni- to ßows to other regions.3 But investment has cations in East Asia, a substantial share of the been low relative to expectations. There has been ßows into the sector has come through build- much activity in signing memoranda of under- operate-transfer schemes (in Indonesia and standing and even in signing actual contracts: in Thailand) that give private operators responsi- mid-1996 some $120 billion worth of projects bilities in a geographic area for a Þxed period. were reported as past the contract award stage. The investment commitments for these projects But the recent history of long development peri- require ÒlumpyÓ Þnancing. By contrast, much of ods and high attrition rates for projects suggests the ßow into Latin America has come through that many now under discussion could unravel privatization of state-owned assets, followed by before Þnancial closure. World Bank estimates of steady growth in new investments. Both regions investment requirements in infrastructure for have received relatively low levels of Þnancing the next decade are $1.2Ð$1.5 trillion (Kohli for transportation projects in recent yearsÑnot 1995). With international Þnance for private pro- surprising given the problems faced by many jects totaling some $9 billion a year in 1995 and such projects. But international Þnance statistics 1996 and domestic Þnance playing a modest role underestimate transportation investment in in most countries, a Þllip is clearly needed to East Asia, since domestic capital markets, espe- ensure the infrastructure expansion critical to cially in Malaysia and Thailand, have been sustaining East AsiaÕs development in the next active in Þnancing transport activities. century (box 1.1). Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 5

Is the slow progress in private investment in Box 1.1 Why expanding infrastructure services in infrastructure a sign of intrinsic problems with East Asia is critical to its future private involvement? Is there, for example, a limit on the availability of long-term Þnancing? A continued push to develop infrastructure services in East Participants at the Jakarta conference tended to Asia is crucial to its development as it enters the 21st century. Why? suggest not. The key constraints lie in the frame- • Growth. Demand for modern infrastructure grows work for private provision of infrastructure. It is at least as fast as the overall economy—and for the resulting lack of bankable, low-risk projects, many sectors signiﬁcantly faster. Failure to meet not the lack of Þnance, that is at the heart of the this demand could undercut the potential rapid present predicament. But this is not to deny the growth. If investment is not boosted in China’s importance of increasing long-term ÞnanceÑand increasingly congested transport system, for of developing weak domestic capital markets in example, the economy’s growth will be choked most East Asian economies. off. The government of the Republic of Korea estimates that infrastructure shortages resulted in a GDP some 16 percent short of its potential in the What is the target? mid-1990s. • Competitiveness. Good power, transport, and Although the share of private investment in East telecommunications services are necessary in rich Asian infrastructure is between 12 and 18 per- and poor economies alike to sustain growth and cent, this overall Þgure is pulled down by the competitiveness in an increasingly integrated low private share in China. The high level of pri- world. In Indonesia industrial ﬁrms that use captive vate involvement in some East Asian economies power pay more than twice the price of power from the grid. suggests that the prospects for private partici- • Quality of life. Poor infrastructure services mean a pation are much greater than current levels in poor quality of life despite rapidly rising incomes— most of the region. especially in urban areas. In many countries house- Hong Kong (China) has traditionally had holds’ access to services remains far lower than considerable private involvement in all sectors would be predicted on the basis of income levels. except water (Kwong 1997). Much private pro- Poor households that have to buy water from ven- vision has also occurred in Malaysia, where dors pay some sixty times the price of piped water in Bandung and almost twenty times the price in power, transport, water, and telecommunica- Manila and Ho Chi Minh City. Congestion in cities tions have all had some infusion of private cap- from Bangkok to Shanghai adds hours to people’s ital (Naidu and Lee 1997). It is difÞcult to daily commute, in air quality conditions way below determine the extent of private investment in World Health Organization standards. Malaysia because the government has contin- Source: ued to have a signiÞcant Þnancial commitment even in ÒprivateÓ projects through equity in privatized enterprises and through grants of land refused to provide guarantees, but its Òcomfort rights, direct subsidies, and concessional loans. lettersÓ have been viewed by the market as But it is likely that the private share is more than assurances that obligations will be honored. half. Elsewhere in East Asia private investment in Private involvement is also high in the infrastructure has been limited. But most Philippines, where World Bank estimates sug- economies are gearing up for greater private gest that about 40 percent of new investment in participation. China has made progress in the infrastructure has been Þnanced through pri- power generation sector with the introduction vate projects (Mikesall 1997). Much of the invest- of model contracts for the Laiban power project. ment in private power projects has beneÞted It has recently had success too with pooling from government backing of the payment oblig- existing power projects to attract Þxed income ations of the National Power Corporation (box investors, using the proceeds for new project 1.2). The recent spurt of private investment in development. Pooling structures are also being Indonesia probably places it at the same level as used for toll road projects (see the section below the Philippines. The Indonesian government has on Þnancing mechanisms). The Republic of 6 Choices for EfÞcient Private Infrastructure Provision in East Asia

The Chilean experience offers a contrast to Box 1.2 Managing guarantees in the Philippines the East Asian strategy (see chapter 4). In Chile In July 1987 the Philippine government launched a program the energy and telecommunications sectors are to attract private investment for power generation (World now almost fully private, there is growing pri- Bank 1994, p. 67). The government provided full faith and vate involvement in transport, and a major pri- credit guarantees to back the obligations of the National vatization of water is planned. What has ChileÕs Power Corporation under long-term power purchase agreements with private suppliers. These guarantees cov- strategy been? Rather than experiment with ered the entire risk of the corporation’s payments: failure to ways to attract investment to speciÞc projects in pay for any reason would trigger the guarantee. With much power and telecommunications, it has focused experience in private power generation and thus a track on creating market structures and regulatory record of honoring payment obligations, the government is institutions conducive to private entry. The in a position to scale back on the guarantees it provides. In result: privatized sectors are seeing rapid invest- 1995 it adopted a policy aimed at doing so, with four objec- ment, face no Þnancing constraints, and receive tives: no explicit or implicit public sector support. • To unbundle the risks so as to be able to sharply demarcate covered risks. Chile has grown 7 percent a year for a decade • To reduce coverage to 75–80 percent of payment and, like most East Asian economies, faces obligations. rapidly expanding demand for infrastructure • To introduce the concept of guarantee “fallaway” services. Of a total projected infrastructure (for example, the guarantee of foreign exchange investment of $18 billion over the next six years, coverage falls away when the Philippine govern- some $13 billionÑ72 percentÑis expected to ment achieves an investment-grade credit rating come from the private sector. and retains that rating for two years). • To create administrative mechanisms for more In East Asia the scale of private sector careful review, pricing, and budgeting of guaran- involvement in infrastructure will depend on tees, including possibly retaining reserves against societal preferences and on institutional and pol- guarantee claims. icy conditions. Major infrastructure segments, The principles of risk unbundling, reduced coverage, such as feeder roads, will probably continue to be and guarantee fallaway have already been adopted in some publicly Þnanced, and in most of the regionÕs recent guarantees. Now the Philippine government is inves- economies well over half of spending in the next tigating options for a present value budgeting system that decade will be public. Traditional concerns about would reduce the budgetary incentives to provide guarantees (such incentives arise because issuing a guarantee improving the efÞciency of public sector invest- requires no cash, so that no ﬁnancial charge is made against ment programs and infrastructure operation and the department or agency authoring the guarantee). maintenance will continue to be important. Source: Philippines 1995. The policy and institutional framework

Korea has historically had little private involve- A recurrent theme in this volume is the impor- ment in infrastructure. But it recently raised its tance of a clear policy and institutional frame- target for private Þnancing of infrastructure work for private involvement to simultaneously requirements, aiming for a 40 percent share by tackle four related objectives: 2001Ð02, up from the original target of 10 ¥ Reducing the price distortions and risk fac- percent. tors that are central causes of the weak But experience outside East Asia (and in pipeline of bankable projects. Malaysia and Hong Kong, China) shows that ¥ Ensuring that projects are approved efÞ- much higher shares of private infrastructure ciently, fairly, and in a timely fashion. investment are possible. The most striking shifts ¥ Ensuring that private providers deliver high- toward private investment have occurred in quality services efÞciently and at reasonable Argentina and Hungary, where about 70 percent cost. of infrastructure investment is private. In Chile ¥ Dealing with important societal concerns the private sectorÕs share in infrastructure about the environment, resettlement, and the investment is about half (Mikesell 1997). provision of basic services to the poor. Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 7

mental and resettlement issues. There was also Box 1.3 Risks along the project cycle concern about risks during the operational Project development, when risks are greatest, is financed phase, such as changes in contractual agree- almost entirely with equity funds. A drawn-out contract ments (including early termination), inability to award process and a lack of transparency can greatly increase obtain payment for services rendered, and project preparation costs, so high returns are expected from inability to convert domestic into foreign cur- this exploratory work. During the construction period project sponsors typi- rency. Projects in water and transport may also cally seek 70 percent debt financing. Since capital markets face direct market risk. Recognizing these risks tend to be cautious about financing construction, banks are is a Þrst step in designing government policies called on to play a prominent role, and because of the risks and institutions that minimize them. demand relatively large spreads. Since commercial bank Second, there are important differences resources are limited—and there are few banks experi- between infrastructure activities that are poten- enced in international project finance—it is important to tially competitive and those that are intrinsically recycle bank resources into new projects by refinancing pro- monopolistic (box 1.4). Natural monopolies jects through capital markets once they are operational. In principle, governments do not bear construction risk in most require special measures to prevent the granting projects, but as ultimate guarantors in many projects they do of favors to potential monopolists, limit the bear residual risk. abuse of monopoly power, encourage efÞcient Once projects are up and running, cash flows are sub- service provision, and ensure the maintenance ject to market and regulatory risks. The solution is to reduce of asset quality. Much of the initial private sec- the regulatory risks before operation by establishing sound tor activity in East Asia has been in telecommu- sectoral frameworks, including for the environment and for nications and power generation, both resettlement. potentially competitive activities. The following sections outline how the four Not all elements of the framework need be in objectivesÑreducing price distortions and risk place before private entry begins. Indeed, many factors, ensuring timely and fair project conference participants emphasized that there is approval, ensuring low-cost, high-quality ser- no magic formula, and most countries have been vices, and addressing societal concernsÑcan be proceeding in an evolutionary, learning-by- achieved, in monopolistic and potentially com- doing fashion. But an evolutionary policy does petitive activities and in all project phases. not come without costs. From the perspective of potential private investors, evolution is policy Managing the transition in potentially instability and a lack of strategic commitment, competitive activities and it can substantially raise their perceived risks and required returns. Addressing these The countries that have gone furthest in private concerns sometimes will mean striking a bal- involvement in infrastructure have all used com- ance between efÞciency and the need to main- petition in power and telecommunications. Of tain commitments to the private sector when the the countries represented at the Jakarta work- rules of the game change because of deeper sec- shop, Australia, Chile, and Malaysia have multi- toral reforms, as authorities in Victoria, ple, competing operators in telecommunications. Australia, did in grandfathering a guarantee to This approach is based on the view that, since a major power project. there are several technical options for supplying In laying out the elements of a sustainable services (radio, satellite, cable networks, tradi- policy framework, conference participants tional wire lines), there is little reason to restrict emphasized two aspects of infrastructure deliv- new entry into telecommunications networks. In ery. First, there are different phases in an infra- power generation Chile and the Australian state structure project and each has distinct risks (box of Victoria have competitive structures. 1.3). Private sector representatives expressed Competition in East Asia is extremely lim- great concern about risks in the development ited, even in telecommunications. Indonesia and phaseÑin the contracting process, the granting Thailand have awarded private telecommunica- of permits, and the management of environ- tions providers concessions to serve speciÞc 8 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 1.4 Policy issues in competitive and monopolistic infrastructure sectors Technological change has made power generation and long- turn to higher-cost alternatives, such as water vendors, alter- distance telecommunications potentially competitive and will native energy sources, or competing transport modes. But sub- soon do the same for electricity distribution and local calls. stantial market power and special pricing problems remain as Many other activities are at least in part natural monopolies, policy issues. Competition is a desirable goal, but achieving and especially network industries, such as electricity transmission, enforcing it can be a demanding task for policymakers. Relapses gas and water supply, and road and rail transport. into monopoly characteristics are common. Different policy issues arise in monopolistic and competi- Source: tive activities. In natural monopoly sectors consumers can often

Policy objectives in competitive and monopolistic infrastructure sectors Development phase Service delivery phase Potentially competitive sectors (electricity • Designing market structures for the public • Implementing general competition policy, generation, long-distance telecommunications) to private transition including network interconnection • Establishing rules for environmental and arrangements resettlement issues • Providing explicit subsidies for basic services • Reducing the public sector’s direct role in for the poor contracting

Natural monopolies (electricity transmission • Efﬁciently managing the contracting process, • Regulating the sector to ensure fair pricing, and distribution, toll roads, ports, water using “competition for the market” low-cost service delivery, high-quality service, supply) • Managing environmental and resettlement and adequate future investment issues • Providing explicit subsidies for basic services for the poor

geographical areas, but have also granted them investment. Victoria attracted surprisingly high monopoly rights in those areas. Awarding con- bids on assets sold even without offering a com- cessions to several providers creates the poten- mitment through a take-or-pay contract (box tial for ÒyardstickÓ competition, in which 1.5). While the models for introducing competi- suppliers are rewarded on the basis of compar- tion differ from one country to another, they isons with suppliers in other jurisdictions, but share the goal of stimulating competition for this type of competition is necessarily weaker ÒspotÓ supplyÑthe daily supply to the trans- than direct competition. mission grid. In spot markets only the plants In power generation in East Asia private able to win the right to supply the daily grid entry has been through long-term, take-or-pay requirements on the basis of their low costs are power purchase agreements between private paid. There is an incipient movement in the suppliers and government-owned power com- Philippines to create competition in power sup- panies. Under a take-or-pay contract the power ply along these lines. company makes a commitment to pay the pri- Other countries in East Asia are also consid- vate operator a capacity fee, which typically covering sectoral reforms in power. Reform is high ers at least debt and operating costs, whether or on the agenda in China, for example. Countries not it actually uses the power. Thus, even where where private entry is at an early stage can skip there are multiple private generators, they do the stage based on BOTs and power purchase not compete directly. Investments under such guarantees. But there are important precondi- contracts typically occur through build-operate- tions for successful competition. The utility buy- transfer (BOT) arrangements and are primarily ing power must be creditworthy, or new entry is a device to help governments Þnance new unlikely to occur. Price reforms are necessary to capacity by deferring payments. ensure the sectorÕs viability. Reforms of the The experiences of both Chile and Victoria, power utility may also be needed, often includ- Australia, in introducing competition in power ing privatization. And competition requires a supply illustrate gains in both efÞciency and regulatory infrastructure, including Òpower Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 9

Box 1.5 Beyond power purchase agreements—man- Box 1.6 Leaving the contracting choice to the aging the transition to competition in power generation market—the gas pipeline in Chile In the Philippines a framework for competitive electricity A pipeline to transport natural gas over the Andes from supply is beginning to emerge and will probably be put in Argentina is an important option for energy supply in Chile. place in the next three to five years. The country will then Once constructed, such a pipeline would be a natural have to decide how to handle existing power purchase monopoly. Negotiations to construct a pipeline started agreements. For guidance, it can look to the Australian state between the government and potential developers, who of Victoria, which has already made the transition to com- emphasized the need for government guarantees to make petition. the project viable. But the government, judging that it had The first major private entry in Victoria’s power gener- little basis on which to negotiate, left the developers to nego- ation sector was through the sale of the half-finished, 1,000- tiate directly with the potential users. Of the two consortia megawatt Loy Yan B plant. Negotiations were long, costly, that competed for the right to serve customers, one even- and complex but eventually ended in a deal involving a thirty- tually struck a deal with a group of consumers at a price far three-year take-or-pay power purchase agreement and the lower than that originally proposed to the government— state electricity utility taking all the construction risk . When with no government guarantee of the purchase contracts. Victoria later introduced full competition in generation and Source: Chapter 4 in this volume. complementary reforms in transmission and distribution, it chose to grandfather the power purchase agreement with Loy Yan B in order to avoid destabilizing the business envi- Ensuring competition for the market and timely ronment—despite potential efficiency losses. and efÞcient contracting The priority given to a stabile business environment, combined with deep sectoral reforms, has led to strong pri- Many infrastructure projects are not in compet- vate interest—without the government having to offer guarantees. One measure of private interest is the purchase of itive activities, either because they are natural the thirty-year-old Hazlewood power plant for three times monopolies or, as in much of the power and its book value, with no power purchase agreement. This telecommunications investment in East Asia, sale, along with sales of distribution companies, has helped because service provision has not yet been transform the state’s finances. deregulated. Investment in noncompetitive Source: Chapter 2 in this volume. activities generally implies direct government management of the choice of project and the award of contract, an approach that raises dif- poolsÓ and mechanisms to ensure fair dispatch ferent concerns for the public and private sec- (and thus the choice of generating plants with tors. Government representatives at the the lowest marginal cost of supply). conference particularly emphasized the need to Competition eases the task of regulation, ensure fair deals for society and avoid the exces- since it fosters efficiency and fair pricing. But sive proÞts (and political fallout) associated merely permitting new entry is not always with highly favorable contracts. Private sector enough to make market structures competi- representatives expressed concern about lack of tive. Market structures created at the time of clarity in the rules of contracting and the cost of restructuring or privatization can have long- the process, which is Þnanced entirely with lasting influences. Chile allowed a vertically equity and must therefore yield a high return. integrated power company, creating a poten- Where direct competition in supply is lim- tial for the company, as owner of the grid, to ited, another potential source of discipline is give preference to the generating plants it competition Òfor the market,Ó or for the right to owned. By contrast, Victoria, Australia, moved supply. Such competition requires governments to five generating companies and an indepen- to identify projects, invite competitive bids, eval- dently owned grid when it deregulated. Even uate the bids, and award contracts. To exploit the after the principle of competition is estab- potential of such competition, governments need lished, the regulator or competition authority to establish the basic rules and legal framework needs to keep an eye out for anticompetitive for eligible projects, identify qualiÞed suppliers, tendencies. and conduct individual transactions that result in prices that are fair and beneÞcial to consumers 10 Choices for EfÞcient Private Infrastructure Provision in East Asia and are perceived as such. Where private indifference to consumer needs often result. But involvement is mature and consumers are well despite the obvious beneÞts of competitive bids, informed, the government can withdraw from many projects are still procured through direct the contracting processÑas the Chilean govern- solicitation or in response to private sector pro- ment did in natural gas supply (box 1.6). posals. For example, in Malaysia, which has the East Asia already has some of the basic legal largest portfolio of private projects in East Asia, structure in place for private sector entry, but a virtually all projects have been directly pro- large agenda of legal reform lies ahead. In such cured. Proponents of noncompetitive bids cite countries as Cambodia, Mongolia, and Vietnam, several beneÞts. The procurement process takes where no private projects have been imple- less time. Overall preparation costs are lower, mented, the rules for BOT projects are still in the since the costs that would have been incurred by early stages of development. In China several unsuccessful bidders are eliminated. And unlike private projects are in operation, but the BOT in a competitive situation, where all bidders policy continues to evolve. Laws permitting must respond to a common basic request for pro- water and road concessions are needed in most posals, the private sponsor has the opportunity countries, as are extensive legal changes to allow to show innovation in project design. privatization of state assets. Several conference Examples presented at the conference participants stressed the need for a legal struc- showed that the gap between competitive and ture that would increase conÞdence in the con- noncompetitive contracting can be narrowed by tracting process among potential suppliers and overlaying on one the positive features of the eventual consumers and thus lower the costs of other. For example, a government could subject completing transactions. a sole-source bid to an open and competitive The economic and social beneÞts of a project price challenge before the award, while giving also depend to a great extent on how the contract the initial bidder some preference based on its is procured. While the choice between competi- early design and development costs. The costs of tive and noncompetitive procurement is oftenÑ project preparation could be subsidized to and quite rightlyÑemphasized, other features attract a larger number of bidders, a practice of the transaction can also substantially inßu- used in the United KingdomÕs private sector ini- ence the outcome. Early contracts in a country or tiative and likely to be adopted in the sector are often negotiated directly with selected Philippines. In South Australia authorities con- parties rather than being offered for competitive ducted a negotiation process with competing bid. The Philippines, for example, used direct bidders that was akin to that for sole-sourced negotiations in its initiative to attract private contracts (see box 1.7). Whatever the approach investors to the power sector during the emer- to contracting, preparatory work by the govern- gency period of blackouts. But in recent transac- ment is critical to success. tions it has relied on competitive sourcing; Just as competitive and noncompetitive con- several bidders have typically responded, tracting can share the presumed beneÞts of the resulting in substantial competition and a steady other, they can also share each otherÕs presumed lowering of the purchase price for power. ills. Transparency of process, with a heavy Another successful example of competitive pro- emphasis on information disclosure, is critical, curement has been in Thailand, where bidders regardless of whether a contract is procured com- were invited concurrently to bid on projects to petitively. While a suspicion of political patron- provide up to 4,000 megawatts of power. age is almost inevitable in directly negotiated Competition was extensive, and commitments deals, a competitive process can also be taintedÑ to supply were obtained at the low end of the or at least perceived to be so. There should be no international range. Competitive bidding was presumption that competitive bidding will be also effectively used in Indonesia for telecom- fairly and transparently conducted. Witness the munications contracts. heavy controversy surrounding the award of a The disadvantages of noncompetitive bid- water treatment contract in Thailand and a set of ding processes are well known: high prices and telecommunications contracts in India. Lack of Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 11 clarity on the criteria used in choosing the win- Box 1.7 Managing competition in contracting— ning bidder and a perception that the rules of the South Australia’s experience in water supply game have changed midway through the bidding process are typical sources of controversy. The award of a water supply contract in South Australia Three messages emerge from the experience shows how a competitive bid can incorporate some of the presumed benefits of directly negotiated contracts. in contracting for infrastructure provision. • Prospective bidders were provided detailed tech- Competition can bring major gains in price. nical and financial information based on past oper- Whether the contracting is competitive or not, ation by the public sector, but they also were transparency is highly desirable on both efÞ- invited and expected to undertake their own due ciency and political grounds. And some of the diligence, including assessing demand. positive features of direct negotiations can be • The authorities announced detailed criteria for incorporated into competitive bidding. choosing the winning consortium and for con- ducting any renegotiations. Renegotiation can occur even in competitive situations, and prespec- Using regulation to promote efÞciency ifying the criteria to be used ensures greater transparency. However carefully contract award is conducted, • After receiving proposals from four prequalified it generally must be followed by continual pro- bidders, the authorities entered into a relatively ject oversight to ensure that contract terms are novel—and potentially delicate—set of parallel met and that unexpected effects are not interfer- negotiations with the bidders. They took elaborate ing with societal concerns. Such ongoing over- precautions to prevent the abuse of confidential sight is referred to as regulation. As with information, and they validated the assumptions underlying each bidder’s proposal, limiting the contract award, the processÑand thus the trans- possibility of postcontractual renegotiations. parency and accountabilityÑof regulation is at • The bidding process was completed in eighteen least as important as its technical features. months under the supervision of highly experi- East Asia has limited experience with mod- enced professionals, including international con- ern regulatory practices, but conference partici- sultants. pants agreed that the regionÕs governments Source: need to adopt such practices. These practices increasingly are based on exploiting the incentives of service providers to behave in a socially ulation. Price caps are being used in power gen- desirable manner. This Òincentive regulationÓ eration contracts throughout East Asia, minimizes the information required by the reg- although an important contract for a national ulator to do its job. By contrast, rate-of-return sewerage system in Malaysia is being regulated regulation, now rarely used, imposes high infor- on a rate-of-return basis. mation requirements. In this type of regulation Regardless of the method of regulation, mea- prices are set so as to ensure that the provider sures are required to ensure the accountability receives a speciÞed rate of return, a system that and independence of regulators so that their creates a perverse incentive for the provider to decisions will carry authority. If the relationship increase capital costs while giving the regulator between the regulator, the legislature, and the the difÞcult task of determining the appropriate executive is blurred, as it typically is, it will need level of investment. Another, increasingly pop- to be clariÞed. One view holds that the regulator ular method of price regulation limits prices (or should be accountable to the legislature, with their rate of growth) rather than rates of return. regulatory commissions staffed by members Under this Òprice capÓ system providers have an with overlapping terms so that an entire com- incentive to minimize costs. mission cannot be summarily dismissed. A price cap system does require benchmark estimates of rates of return at the time the cap, or Dealing with broader societal concerns limit, is established. But once set, price caps need be adjusted only every Þve to seven years, lim- Discussions in Jakarta emphasized the impor- iting the information required for effective reg- tance of dealing with societal concerns explicitly 12 Choices for EfÞcient Private Infrastructure Provision in East Asia and early, often with both public and private Box 1.8 Involving the private sector in resettlement involvement. Doing so allows risks and opportunities to be addressed efÞciently. For example, Where truly voluntary resettlement occurs—when land is dealing with environmental and resettlement purchased through fair negotiations—the private sponsors concerns during project development opens of the project can take the lead in addressing the issues. But where involuntary resettlement is necessary, the relationship opportunities for innovative, Òwin-winÓ solu- between the government and the private sponsors is often tions. Similarly, to ensure that the goals of antagonistic. Private sponsors will be unwilling to commit sig- expanded service coverage and affordable ser- nificant new investment because of the uncertainties in pro- vices for the poor are met, they need to be clearly ject design and timetables. Governments may offer to stated up front and reßected in the regulatory undertake the resettlement and even offer financial com- framework and pricing structures. pensation in the event of delays. But such commitments are Resettlement is frequently an important con- not always credible, at least in part because the government cern in infrastructure projects, particularly in actions will be subject to international scrutiny. Close public-private collaboration may offer the way to transportation and hydroelectric projects, and it more humane resettlement at lower cost and in less time. can become a major source of project risk if not The private sector can play an important supporting role, carefully handled. Governments in East Asia are although the government must be prepared to take the lead. devising policies and procedures for resettling The government must set up the consultative process and those displaced by infrastructure projects. the guidelines to ensure fair compensation for those to be Projects involving international lending agen- resettled and to protect their livelihood. But once such cies face increased pressure for effective design guidelines are in place, the private project sponsors can work and implementation of resettlement plans. But alongside government agencies in implementing resettlement—designing and developing new sites and offering the even in projects with purely private investment, people affected work on the project and in spin-offs. the risk of political opposition requires active Source: Chapter 5 in this volume. government involvement to ensure that the concerns of those affected are fairly and equitably addressed through consultation, choice of suit- up paying much higher prices for these services able relocation sites, and adequate support from alternative sources, such as for water from (including compensation) to restore long-term vendors. Many societies have made ensuring incomes (box 1.8). minimum access to basic services a policy objec- Dealing with environmental concerns simi- tive, especially middle-income countries larly requires careful, thorough planning. Most approaching universal access. This often implies project sponsors tend to view environmental subsidizing access for some of the poor, poten- concerns as a source of increased project cost and tially jeopardizing the commercial viability of risk, both during project development and later service supply. Economists generally agree that on, as unexpected liabilities arise due to changes the best approach for achieving minimum access in regulation and the discovery of sensitive envi- while safeguarding commercial viability is to ronmental problems. But perceived risks can provide an explicit subsidy for targeted house- often be turned to the advantage of both devel- holds. A common practice under Argentine opers and society when improved environmen- water contracts, for example, is to bill fully for tal performance goes hand in hand with services, but to have households pay only part increased operating efÞciencyÑas it can in of the bill and charge the government directly water, energy, and transportation projects (chap- for the subsidized portion. In Chile the subsidies ter 5). To realize this potential for mutual bene- for rural electriÞcation are built into contracts Þt, regulators must be clear about the that are then competitively bid. performance standards the project sponsors Issues relating to sector regulation, contract- must meet and allow them sufÞcient ßexibility ing, resettlement, the environment, and reach- in operations. ing the poor converge in the water supply sector. In most countries many people, both poor Few deals in water supply have been Þnalized and nonpoor, lack access to electricity, tele- in East Asia outside of Malaysia, but conference phones, and piped water supply. Often they end participants showed much interest in the sector. Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 13

Box 1.9 Water supply and sanitation—regulation, the environment, and the poor Because water is a basic necessity and clean water is required ernments’ reluctance to award monopoly distribution rights in to prevent the spread of disease, universal access to affordable such a sensitive sector. Some contracts have been awarded to water is a high priority everywhere. But throughout East Asia private operators—a water and sewerage contract in Manila, a water supply systems are under great stress as rapidly growing sewerage contract in Malaysia, a management contract for the urban populations place increasing demands on them. water distribution system in Macao, water sourcing and treat- Perversely, in many systems subsidies have limited the expan- ment contracts in Malaysia and Thailand—and similar contracts sion of supply while failing to beneﬁt the poor, many of whom are under discussion in Chinese and Indonesian cities. But the lack access to the public system and buy water at high prices needs extend well beyond these early efforts. from private vendors. Sewerage systems are even less devel- Regulating the water and sanitation sector is a challenge oped and service prices are much too low to cover the sub- because large investment requirements and high environmen- stantial investments required. As a consequence, poor tal standards imply a need for long-run price increases. sanitation is a growing threat to public health and the environ- Balancing the goals of expanding access, including to the poor, ment in many countries. protecting the environment, and preventing abuse of monop- Private entry into water and sanitation has been con- oly rights creates a policy challenge that can be met only strained by system inefﬁciencies, uneconomic pricing, and gov- through increased experience and public-private collaboration.

Because of the complexity of the issues in the cial assets, with bank credit, for example, com- water and sanitation sector, it is an important parable to levels in some industrial countries new frontier for public-private partnership in (Þgure 1.6). the region (box 1.9). So the issue is clearly not a lack of domestic resources. Even if the private sectorÕs share in Capital Markets and Domestic Finance for infrastructure investment in East Asia reaches 30 Private Infrastructure percent in the next few years and more than 50 percent by early in the next century, it would still In most East Asian economies the bulk of Þnance amount to only 2Ð5 percent of GDP, a small frac- for private infrastructure has come from foreign tion of private domestic savings. Instead, the sources. Yet most of the revenues from infra- low domestic Þnancing for private infrastruc- structure projects are in domestic currency, raising the risk of currency devaluation and foreign Figure 5 East Asia has extraordinarily high savings . . . exchange inconvertibility for foreign investors. Gross domestic savings as a percentage of GDP, 1993–95 The risks for foreign Þnance of private infrastructure increase the importance of domestic 0 10 20 30 40 50 Singapore Þnance. But only about a quarter of the Þnance for private infrastructure in East Asia comes China from domestic sources. Malaysia Why has there been so little domestic Þnanc- Thailand ing for private infrastructure? The low levels in Indonesia East Asia today are not without historical prece- Korea, Rep. of Developing East Asia dence. Much of the Þnancing for some of the average infrastructure developed in North and South Hong Kong, China America in the nineteenth century came from Japan the capital markets of the United Kingdom Germany (Eichengreen 1996). But domestic savings in the Brazil recipient countries were low. By contrast, East India Asian economies have some of the highest sav- Mexico ings rates ever recorded (Þgure 1.5). Total sav- Argentina ings are running at 30Ð35 percent of GDP, and Philippines private savings at 25Ð30 percent. Moreover, a sig- niÞcant share of the savings is going into Þnan- Source: World Bank. 14 Choices for EfÞcient Private Infrastructure Provision in East Asia

Figure 6 . . . much of it channeled into financial investment Despite East AsiaÕs gradual approach to privati- Total credit provided by the banking sector as a percentage of GDP, 1995 zation of state-owned utilities, almost $11 billion 0 50 100 150 200 250 300 was raised on foreign and domestic stock mar- Japan kets in 1989Ð95 (compared with $28 billion in Hong Kong, China Latin America), almost entirely for power, trans- Thailand port, and telecommunications (table 1.2). For United States example, PT Telkom, the Indonesian telecom- Malaysia munications company, went to the market with Germany an initial public offering in November 1995 and United Kingdom Average for raised $1.69 billion, mainly onshore, on the developing East Asia Jakarta and Surabaya stock exchanges and later China raised some $600 million through an onshore Singapore private placement. The private Indonesian toll Korea, Rep. of Philippines road company, Citra Marga Nusphala Persada, Mexico also has raised some $600 million on local stock Indonesia markets. But with foreign investors accounting India for almost 80 percent of trading on the Jakarta Brazil exchange, and about 50 percent in Bangkok, Argentina Kuala Lumpur, and Manila, the estimate of

Source: Walton. onshore Þnance includes a large share of foreign Þnancing. ture stems from a combination of relatively Stock markets are likely to become an impor- immature domestic capital markets, especially tant source of Þnance for infrastructure compa- bond markets, and domestic investorsÕ cau- nies in East Asia. Although the depth and tiousness about such investments. Apparently, institutional framework of the regionÕs domestic investors are more averse to the risks exchanges are less well developed than those of associated with the present phase of infrastruc- mature exchanges, stock markets throughout the ture investment than are foreign investors, who region are growing and deepening fast. By one have greater opportunities for diversiÞcation. In estimate the Kuala Lumpur exchange saw a dou- the coming years use of domestic equity markets bling in efÞciency between 1992 and 1996, and is likely to grow rapidly, but long-term domes- the Jakarta exchange improved nearly as fast. tic debt Þnance will probably lag in most coun- Although East AsiaÕs stock markets are still tries, taking off only when domestic contractual young, capitalization in several is comparable to savings become signiÞcant, as has occurred to or greater than that in rich countriesÑand is some extent in Malaysia. (Contractual savings growing fast (Þgure 1.7). Stock market capital- have also been used in Singapore, but in a pre- ization in Hong Kong (China), Malaysia, and dominantly public sector context.) Singapore was more than 200 percent of GDP in 1995¾substantially greater than in the United Equity markets Kingdom and the United States. The exchanges in Thailand and the Philippines also had high

Table 1.2 Equity market ﬁnancing of infrastructure privatization in East Asia and Latin America, 1989–95 (US$ billions) East Asia Latin America Sector Onshore Offshore Total Onshore Offshore Total Transportation 2.2 1.2 3.4 3.1 0.9 4.0 Telecommunications 1.7 2.2 3.9 4.3 11.4 15.7 Power 2.5 0.9 3.4 3.9 4.4 8.2 Other 0.1 0.1 0.2 0.1 0.0 0.1 Total 6.5 4.3 10.9 11.3 16.7 28.0

Source: World Bank, International Economics Department, Privatization Database. Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 15

Figure 7 Stock market capitalization in several East Asian Figure 8 Bond markets are still relatively undeveloped economies is high and growing fast in East Asia Stock market capitalization as a percentage of GDP, 1990 and 1995 Bond market capitalization as a percentage of GDP, 1990 and 1994 0 50 100 150 200 250 300 0 20 40 60 80 100 120 1990 Malaysia 1995 1990 United States 1994 Hong Kong, China Singapore Germany United Kingdom Japan United States Singapore Thailand Philippines Malaysia Japan Philippines Korea, Rep. of Average for East Asia United Kingdom India Korea, Rep. of Mexico Thailand Indonesia Germany Hong Kong, China Brazil China Argentina China Indonesia Source: Walton. Source: World Bank. levels of capitalization (though ThailandÕs has since fallen back). Finance from stock markets assets (originally Þnanced by public or private will, of course, depend on the perceived riski- equity or debt Þnance) to raise resources on ness of projects. In mid-1997 Malaysian local and international capital markets to investors showed signs of caution over some Þnance additional investments could emerge as infrastructure projects: a June 1997 rights issue a signiÞcant pattern. for the Þnance of the 2,400-megawatt Bakun Dam was reported to be 63 percent undersub- Debt Þnance and bond markets scribed (Financial Times, June 12, 1997). A relatively new development is the raising While there has been signiÞcant activity on East of funds through securities backed by pooled AsiaÕs domestic equity markets (though much of infrastructure assets. Several Chinese pro- it involving foreign investors), domestic debt jects issued such securities to raise Þnancing on Þnance of private infrastructure has been rela- the Hong Kong (China) and the domestic tively limited. Does this reßect failure by the Shenzhen stock exchanges. For example, in 1996 domestic Þnancial system to efÞciently interme- the Guangdong Provincial Expressway diate private savings into proÞtable investment Company raised HK$477.9 million (US$62 mil- opportunities? The answer is yes, but the prob- lion) through an issue of B shares on the lem relates to the current phase of Þnancial mar- Shenzhen exchange, backed by stakes in com- ket development rather than short-run policy. pleted revenue-generating toll projects, includ- Banks still dominate East Asian Þnancial sys- ing the Jujiang Bridge and Guangzhou-Foshan tems and account for the bulk of private savings expressway. The money raised was used to in Þnancial instruments. Deposits are mainly Þnance additional investment. In late 1996 the short to medium term, limiting banksÕ ability to Anhui Expressway Company raised $100 mil- make the long-term investments typical in infra- lion on the Hong Kong (China) exchange to structure projects. East Asian banks also have Þnance three highway projects, with the com- less capacity to support large-scale projects than panyÕs balance sheet secured by the Hening do the much larger and Þnancially stronger Expressway, already in operation. This use of international banks. 16 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 1.10 Contractual savings in long-run finance for infrastructure Chile. Chile’s independent pension funds have become major (the Netherlands is unusual in Europe in having fully funded players in domestic infrastructure finance, through purchases of pension schemes). both bonds and equity. Since they were privatized, the funds The United Kingdom. The First Hydro project involved the have channeled some $4.8 billion into electricity and gas dis- first-ever use of a sterling eurobond issue for project finance. tributors and $1.6 billion into telecommunications companies This hydro plant was bought by Mission Energy in 1995 and and are becoming increasingly involved in transportation. refinanced through issuance of £ 400 million of 25.5-year Malaysia. The first independent power project awarded in eurobonds. Most of the bonds were purchased by British insur- Malaysia, the YTL power generation project, was financed ance companies. entirely in local markets, including through a 1.5 billion ringgit The United States. The Independence Funding (RM) (almost $500 million), ten-year bond subscribed by the Corporation, which owns a 1,000-megawatt gas-fired cogen- Employee Provident Fund and a RM 1.6 billion floating rate loan eration plant in New York State, was the first independent underwritten by local banks to finance construction. power producer in the world to receive an investment-grade Subsequent projects using bond finance have included other rating and obtain finance through the capital markets. Backed power projects (Lumut Power) and transport projects (the by strong power offtake agreements, its successful offering in North-South Expressway). The Employee Provident Fund has 1993 of secured notes totaling $717 million was purchased been active in most of these bond issues. mainly by U.S. institutional investors. In 1995 California Energy The Netherlands. The Wijkertunnel was the first project in issued $200 million of limited recourse, below-investment- continental Europe to be financed through domestic markets. grade bonds with eight-year maturities. It raised most of the tunnel’s $342 million cost through private Source: placement of bonds with Dutch insurance and pension funds

Financing infrastructure through long-term manage contractual savings with long maturi- bonds is an attractive option in principle. Bond ties, long-gestation infrastructure projects are markets were an important source of Þnance in potentially attractive investment opportunities earlier eras of private infrastructure, notably in as long as risks are adequately addressed. the building of transport networks in North and Most developing countries have a relatively South America (see Eichengreen 1996). In the small pool of institutional investors, however. more recent past bond Þnance was used primar- Two of the exceptions are Chile and Malaysia. In ily by state corporations¾as in French power both countries pension funds have played an investments and the U.S. Tennessee Valley important part in infrastructure Þnance, Authority. In Indonesia the state-owned power although under very different market condi- company Perusahaan Listrik Negara (PLN) has tions. In Chile pension funds are private and similarly made use of the local bond market, autonomous, and they compete for resources becoming one of the major market players. It from individual workers, though within fairly made its Þrst bond offering in 1992, of 300 billion narrow limits. The government has steadily rupiah (Rp), and issued another Rp 2.6 trillion at broadened the range of assets that pension the end of 1996, mainly of Þve- to seven-year funds may purchase. In Malaysia there is much maturities. In general, however, bond markets in greater state involvement in the economy, and East Asia are relatively undeveloped, with the Employee Provident Fund is a public entity turnover much lower than in the developed with relatively restricted investment options. markets of industrial economies (Þgure 1.8). Until recently the fund held the bulk of its The use of bonds in limited recourse project investment in government bonds (and still holds Þnance has emerged in recent years. The issues about half in this instrument), but it is now pur- have been placed in relatively well-developed suing a more diversiÞed investment policy. Þnancial markets, primarily the U.S. 144a mar- Bond markets in East Asia are relatively ket (which permits resale of purchased securities underdeveloped in part because of the relatively to qualiÞed investors). Institutional investors, low issuance of government bonds, which usu- primarily insurance companies and pension ally provide the core of the bond market¾and funds have been the major purchasers of these that in turn stems from the low levels of deÞcit bonds (box 1.10). Because institutional investors Þnance. Underdeveloped bond markets also Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 17 reßect the relatively limited use of external ing-by-doingÓ phase, jumping directly to deeper Þnance by the corporate sector, owing to the reforms and the gains they bring in efÞciency, dominance of family Þrms. Bond markets are investment growth, Þnance, and public conÞ- certainly growing in importance, and the insti- dence. tutional framework is likely to improve rapidly, The Jakarta dialogue and other public-pri- as it did for equity markets, with the develop- vate forums organized by the World Bank con- ment of benchmarks, improved settlement and Þrm that while private participation in clearance procedures, and an information infra- infrastructure is new and the issues complex, a structure (World Bank [Asian Bond Market rich body of experience is fast developing. This Study]). experience reveals major differences between As emphasized throughout this volume, sectors and countries, suggesting that no one however, infrastructure investments continue to model is universally applicable. Yet the discus- involve signiÞcant risks, a concern for investors sions between policymakers and private execu- looking for the relatively moderate but secure tives have identiÞed common principles and returns characteristic of bond markets. strategies that can help countries shorten the Experience suggests the need for caution in forc- learning curve and develop more effective ways ing the pace: many technically autonomous to promote private participation (Kohli 1997). public pension funds in Latin America saw a Among the lessons that have emerged from substantial share of their investments channeled such discussions are the preconditions needed into low-return activities. More important is to to ensure the sustainability of large-scale private reduce the risks faced by infrastructure projects investments in infrastructure: and to foster the development of genuinely ¥ Projects must produce services at prices the autonomous contractual savings institutions public is willing to pay. that will make prudent decisions on purchases ¥ Where government subsidies or other forms of infrastructure bonds and other savings instru- of support are essential, they should be trans- ments. With further pension reforms likely in parent and sustainable. East Asia and great potential for growth in life ¥ Private projects must be Òbankable,Ó that is, insurance, large growth can be expected in the their Þnancial returns must be commensu- savings available for long-term investment. But rate with the risks perceived by private this growth will not happen overnight. investors and Þnanciers. To meet these preconditions, most countries A framework for moving forward need to undertake far-reaching policy and institutional reforms to improve the Þnancial viabil- There is no magic formula for accelerating pri- ity and proÞts of infrastructure projects, increase vate sector involvement in infrastructure, but competition and transparency in contracting, there is a set of common principles for fostering and reduce the risks of investing in the sector. such involvement while achieving efÞciency Such reforms build credibility with both the gen- gains and meeting societal goals. These princi- eral public and private investors. plesÑtransparent processes, stable rules, price The goals set for private participation frame- reforms, maximum competition, and incentive- works vary among countries and sectors and based regulatory structuresÑare the pillars of a continue to evolve. But they are likely to include: basic framework that each country can cus- ¥ Price reforms that ensure sustainable rev- tomize to Þt its priorities and institutions. enues and reduce future price uncertainties. Developing effective frameworks for private ¥ A more transparent and credible regulatory participation will be an evolutionary process as and legal framework. countries learn from their experience. But sys- ¥ Greater competition (including the breakup tematic sharing of information among East of monopolies, whether public or private). Asian economies and with other countries at all ¥ Direct relations between the ultimate con- stages of development will speed this process. It sumers and suppliers to enhance account- may also enable late starters to skip the Òlearn- ability. 18 Choices for EfÞcient Private Infrastructure Provision in East Asia

framework for mitigating and sharing risk, and Box 1.11 The role of multilateral agencies in put in place policies and procedures for transpar- promoting private participation in infrastructure ent and competitive bidding and contracting in Many participants at the Jakarta seminar believed that the order to take advantage of competitive market World Bank and other multilateral institutions also have a forces and reduce transaction costs. And they crucial role to play in bringing about a sharp increase in pri- need to redouble efforts to develop domestic bond vate participation. They proposed that this role focus on: • Supporting continued public-private dialogue at markets and Þnancial instruments to support both the country and the regional level. long-term investment in infrastructure projects. • Sharing information and lessons of experience Regional sharing of information and other from within and outside the region. forms of cooperation could contribute much to • Helping countries develop a more conducive the initiative. As the trade liberalization initia- framework for private participation. tive of Asia-PaciÞc Economic Cooperation • Formulating standards for bidding and contractual (APEC) showed, when economies take parallel documents. or complementary actions in a policy area they • Supporting the development of new ﬁnancing mechanisms and the design of a policy framework create important synergies and momentum, and for domestic ﬁnancial sector development, includ- multicountry initiatives yield economies of ing bond markets. scale. To help maximize the beneÞts for reform- • Financing more privately sponsored projects in a ing economies, countries with more developed way that maximizes the leveraging of Bank com- markets could take steps to promote a greater mitments. ßow of private investment and management skills across the region. Five sets of actions across the Asia-PaciÞc ¥ Separation of sovereign and commercial region would help create these important syner- risks to allocate risks efÞciently. gies and ensure the full beneÞts of the reforms ¥ The development of domestic capital mar- for all economies in the region: kets and of mechanisms to facilitate provi- ¥ Reorient policies and practices of export sion of long-term debt, including the creation credit and ofÞcial development agencies to of Þxed income securities and bond markets. directly support private projects. In some Most developing economies in the region are cases this may require increasing the addressing many of these constraints and issues. resources available to these agencies. The But almost all are focusing on the needs of a few Japanese government has recently made a projects or sectors, addressing only some of the policy decision to provide greater support to cross-sectoral issues, and pursuing reforms private Þnancing of infrastructure projects in more slowly than desirable. At this pace and East Asia and has asked the Japanese Export- intensity, developing a robust and complete Import Bank and Overseas Economic framework will take a long time, delaying the Cooperation Fund to reßect this decision in full gains from private participation. their operating strategies. Other industrial The high-level dialogue at Jakarta and at economies could take similar steps. regional political forums offers a potential plat- ¥ Provide a larger volume of political risk form for launching a comprehensive initiative insurance to viable private investments. As aimed at developing a complete framework in the Japanese government has recently sug- all the regionsÕs developing economies within a gested, there is also a need to multi-source similar timeframe. Such a regionwide initiative insurance and export credit, with greater is essential if the target of a 30 percent or greater involvement of agencies from the more private sector share in infrastructure invesment advanced developing countries. is to be met by the end of this century. ¥ Remove regulatory barriers and other disin- To achieve this target, countries need to for- centives to investment by infrastructure mulate (or clarify) their objectives, strategies, and providers and institutional investors in the priorities for private participation. They need to region in otherwise creditworthy infrastruc- streamline internal decisionmaking, develop a ture projects. Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 19

¥ Provide more technical assistance (through The discussion on regulation is continued in grant funds and expertise) to the developing a thematic chapter by Bradford Gentry on envi- economies for policy reforms and institu- ronmental and resettlement issues in infrastruc- tional development. ture projects (chapter 5). These issues are clearly ¥ Share information and lessons of experience of great importance to society, and they have in both industrial and developing economies also become key risk factors for private devel- and foster public-private dialogue through opers and investors. The chapter shows that it is the regional forumsÑAPEC, the Association best to make resolving environmental and reset- of South-East Asian Nations (ASEAN), and tlement concerns an integral part of the project the Asia, Europe, and Mediterranean (ASEM) cycle. The Þnal chapter, by Montek Ahluwalia, association. discusses a broad range of Þnancing questions, focusing on risks associated with infrastructure What follows provision and drawing especially on examples from India. The chapters in this volume discuss the issues of private provision of infrastructure from the per- Notes spective of practitioners and policymakers deeply engaged in them. Chapter 2, by Donald Russell, 1. The focus here is on international financing describes the experience of Australia in designing because consistent data across countries and over time have recently become available, while comparable data a reform strategy and making the transition from on domestic financing of infrastructure are not yet an incremental, project-speciÞc approach to more available. The reader is thus cautioned that the picture ambitious structural change. This experience presented is incomplete. While the intercountry com- shows how a move to sectorwide reform, with parisons and trends are broadly indicative of overall broad competition and clear rules of the game, can financing patterns, they may be less useful for countries such as Malaysia and Thailand, where there has reduce the need for project-speciÞc guarantees been signiÞcant domestic Þnancing of infrastructure. and stimulate active interest among private 2. The data here on international infrastructure investors, with substantial gains for the treasury. Þnancing cover closed and signed transactions of inter- Chapter 3, by Yahya Yaacob and G. Naidu, national loans and bond and equity issues reported by uses the experience of Malaysia as the basis for capital market sources. The data have been provided a discussion of the choices and tradeoffs in dif- by the World BankÕs International Economics Department. ferent methods of contracting with the private 3. This section draws on World Bank 1996. sector. Contracting has become a central feature of the current phase in private delivery of infrastructure and will always be important in areas References where a competitive model of delivery is not feasible. Malaysia has pursued a relatively man- Eichengreen, Barry. 1996. ÒFinancing Infrastructure in aged approach to contracting, in contrast to the Developing Countries: Lessons from the Railway Age.Ó In Ashoka Mody, ed., Infrastructure Delivery: competitive model increasingly used in other Private Initiative and the Public Good. EDI countries. Development Studies. Washington, D.C.: World The Chilean experience, discussed in chapter 4 Bank. by Alejandro Jadresic, demonstrates the central Kohli, Harinder. 1995. ÒInfrastructure Development in importance of a regulatory structure and the com- East Asia and PaciÞc: Towards a New Public-Private Partnership.Ó World Bank, East Asia and Pacific, mitment required to establish such a structure. OfÞce of the Vice President, Washington, D.C. Like Australia, Chile has been able to curtail gov- ÑÑÑ. 1997. ÒDeveloping Infrastructure for the New ernment guarantees by creating regulated markets East Asia: Forging a Public-Private Partnership.Ó In in which contracting parties reach outcomes in line International Chamber of Commerce, Building the with commercial principles. The chapter also dis- New Asia. cusses how Chile has dealt with major societal con- Kwong, Sunny Kai-Sun. 1997. ÒHong Kong: Private Participation with Strong Government Control.Ó In cerns, including environmental issues and the Ashoka Mody, ed., The Untold Story: Infrastructure provision of infrastructure services to the poor. Strategies in East Asia. Washington, D.C.: Economic Consultative Document.Ó Manila. Development Institute, World Bank. World Bank. Asian Bond Markets Study Mikesell, Deborah Newitter. 1997. ÒThe Range of ÑÑÑ. 1994. World Development Report 1994: Private Investment in Infrastructure.Ó Infrastructure Infrastructure for Development. New York: Oxford Working Group Background Paper. World Bank, University Press. DECPI, Washington, D.C. ÑÑÑ. 1995. East Asia Bond Market Study. Naidu, G., and Cassey Lee. 1997. ÒMalaysia: The ÑÑÑ. 1996. ÒFrontiers of the Public-Private Interface Transition to Privatization.Ó In Ashoka Mody, ed., in East AsiaÕs Infrastructure.Ó East Asia and PaciÞc The Untold Story: Infrastructure Strategies in East Asia. Regional OfÞce, Washington, D.C. Washington, D.C.: Economic Development Institute, ÑÑÑ. 1997a. Global Development Finance 1997. World Bank. Washington, D.C. Philippines, Government of. 1995. ÒNew Policy on ÑÑÑ. 1997b. World Development Indicators 1997. Guarantees for Private Infrastructure Projects: A Washington, D.C. 2 Organizing the Government for EfÞcient Private Participation in Infrastructure: Lessons from Australia Donald Russell

nmet infrastructure needs in East Asia infrastructure is more complex than originally are constraining both economic growth thought and requires a level of sophistication on Uand social development. Although the part of government that takes time and expe- spending on infrastructure has increased rience to develop. Second, notwithstanding the sharply in recent decades, it has not kept pace stated intention of all governments to involve with demand. Investment in infrastructure rose the private sector in infrastructure, many gov- from 3.6 percent of GDP in the 1970s to about 4.6 ernments are still working through what form percent of GDP in the 1980s and to about 5.0Ð5.5 that involvement should take or have reserva- percent of GDP in 1993, when it reached $70 bil- tions about the appropriateness of private sector lion. But to meet investment requirementsÑ involvement. Such ambiguity and ambivalence estimated at $1.3Ð$1.5 billion between 1995 and on the part of government can cloud the true 2004Ñthe investment to GDP ratio will have to nature of the risks associated with any infra- rise to 6.5Ð7 percent. Past methods of funding structure project and lead to long delays in get- infrastructure, which depended heavily on ting governments to make key decisions. export credit organizations, multilateral lending This chapter looks at the role of government institutions, and aid agencies, will not be able to in involving the private sector in infrastructure fund the required growth. Nor will govern- development. It draws on experience in the ments in the region be able to raise the necessary region, particularly in Australia, to set guidelines funds through tax revenues, borrowing, or for government processes and organization. increasing revenues of public utilities. AustraliaÕs experience with infrastructure Given these massive investment needs and provides some interesting insights. During the the inability to Þnance them themselves, it is nat- 1960s Australia invested 9 percent of GDP in ural that East Asian countries would look to the infrastructureÑalmost all of it publicly private sector to provide needed capital. But fundedÑto meet the post-War surge in immi- experience with the private sector has failed to gration. Since then the Þgure has fallen to 6 per- meet expectations, raising doubts about cent as a result of a sharp cutback in government whether it can participate in infrastructure funding, but private infrastructure has development in a way that leaves countries and expanded substantially and now accounts for their communities better off than they otherwise about 20 percent of total investment. Financial would have been. closings worth $4 billion in private infrastruc- ÒThe original high expectations of the host ture were signed in 1995, representing 80 per- countries and of private sponsors have not been cent of private investment in infrastructure in metÓ and Òneither the governments nor private East Asia. sector are satisÞed with progress,Ó according to AustraliaÕs involvement with private infra- the World Bank (1995). What went wrong? structure began around 1987. The federal gov- Experience in the region points to two main ernment created an environment that problems. First, involving the private sector in encouraged development of private infrastruc-

21 22 Choices for EfÞcient Private Infrastructure Provision in East Asia ture, but complex federal/state issues have works that give structure to particular pro- meant that progress has not been guided by a jects and reduce risk blueprint from Canberra. Many lessons have ¥ Willingness to put in place the distribution been learned from this process, and a large pri- facilities necessary for a private project to vate infrastructure industry has developed in succeed. This is particularly important in Australia, backed by a range of institutional countries in which private interests are not investors. Australian design and construction permitted to own distribution facilities. companies, law Þrms, and investment banks ¥ A track record of success have expanded and used their experience to Companies look for commitment from govern- build businesses in East Asia. ment within both the narrow context of formal The chapter is organized as follows. The Þrst project negotiations and the wider context of pri- section lays out the complex issues involved in vate infrastructure policy. private infrastructure and shows why govern- Paradoxically, although the private sector is ment commitment is so important. The second providing a growing share of infrastructure section examines the competing interests of the investment, the governmentÕs responsibility for various government agencies involved in pri- guiding the process may be greater than it was vate projects and considers the implications for when the system was exclusively public. This private infrastructure. The third section shows increased responsibility stems from the fact that how governments try to resolve the problems adding a private component to the system raised by the complexity of the issues and the makes the system more complex and hence large number of agencies involved, and the requires more sophisticated government man- fourth section suggest how governments might agement. reorganize to improve private-public cooperation and ensure that they obtain the best possi- Variations in the relationship between the public ble deals. The last section draws lessons from the and private sectors Australian experience. Private infrastructure projects invariably The importance of government commitment involve governments at the planning, construction, and operating stages. If a project is part of Key decisionmakers in the public sector must be a broader public system, such as a toll road, a convinced that private provision of infrastruc- water treatment facility, or an electricity genera- ture makes sense, and they must be willing to tor, some public utility or authority will expect follow through on that commitment. Without the new facility to Þt comfortably within its sys- such commitment the contribution of private tems and planning arrangements. There will be infrastructure to the burgeoning infrastructure pressure to use similar equipment, compatible needs of East Asia will be only marginal. technology, and existing contractors and to max- Companies involved in the private infrastruc- imize the value of the public network (existing ture industry typically look for evidence of com- or planned). From the outset tension will exist mitment in the following forms: regarding the exact nature of private sector ¥ Willingness of senior ministers and leaders to involvement. be involved in resolving conßicts affecting At one extreme the project may be a dis- projects guised Þnancing arrangement designed to ¥ Clear signals to government ofÞcials, including extend a public network without appearing to ofÞcials of public utilities, that the leadership add to public sector liabilities. In such arrange- wants particular projects to be successfully ments the public sector bears all the commercial negotiated (although not necessarily to the risk and guarantees that the revenue connected advantage of particular companies) to the project will cover the bond holders who ¥ Willingness to follow through on other pol- Þnance it. The private sector is responsible for icy matters that ßow from particular private the design and construction of the project and projects, such as sectoral plans or frame- for the Þnancing arrangements, which often Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 23 must be innovative if Þnancing is to extend example, will normally be complex and drawn beyond Þfteen years. The public sector seeks to out. Such contracts are used when private infra- have the project built and off its balance sheet to structure augments a public utility network. In avoid the appearance of incurring new liabili- such circumstances the public utility purchases ties. If the public sector cannot borrow, it seeks the output of the private project. The viability to get the project built as cheaply as possible. If and attractiveness of the project will be deter- the private project is privately operated, there is mined by the nature and robustness of the con- the potential for operating efÞciencies and tractual relationship between the project and the ÒbenchmarkingÓ of other parts of the public net- government, and enormous effort will go into work, something that is often attractive to pub- negotiating this contract. lic sector managers. At the other extreme, a All investment decisions by the private sec- project can be completely commercial, with the tor involve government approval processes to equity holders bearing full risk and bond hold- some extent, but private infrastructure projects ers or commercial banks receiving no guaran- are in a class of their own because of their long tees. Output carries a market-determined price, lives, their potential for abuse of market power, and equity holders can reap large returns if the and the long tradition in many countries of util- project is successful or lose their investment if ities serving a social as well as an economic func- the project fails. In between these two extremes tion. The private sector will have to comply with there is scope for different kinds of guarantees a wide range of government approval proce- and allocation of risk between the government dures, involving foreign investment regulations and the private sector. and exchange controls, export and import con- The importance of the governmentÕs role trols, environment and zoning regulations, the cannot be overstated. The government deter- sourcing of equipment and other inputs, and mines the exact nature of the project and must be local employment requirements. very clear about what it is trying to achieve in order to prevent confusion and frustration on all Case studies from Australia sides. If, for example, the government wants to negotiate a deal that is really a disguised Þnanc- The Australian experience illustrates the impor- ing arrangement but is loathe to provide guar- tance of government commitment and the way antees out of concern over its credit standing in government commitment develops. In the mid- the eyes of the international rating agencies, it 1980s Australia went through a process of eco- cannot expect to negotiate narrow margins on nomic adjustment, brought about by the need to the Þnancing. Similarly, friction and costly delay internationalize the economy and cut back on will ensue if private sponsors want to maintain overseas borrowings. The federal government full commercial control of a project while the reduced government outlays to create a budget government wants it to be part of an existing surplus and cut back on the ability of state gov- public network. ernments to borrow. As a result both state governments and the federal government found it The nature of the governmentÕs commitment difÞcult to fund new infrastructure projects. As the 1980s progressed the need to Þnance new Governments need to commit to both the con- infrastructure became more pressing, and the cept of private infrastructure and to individual federal government created a framework within projects. Without a strategy on private sector which the private sector could fund projects participation negotiations over individual pro- viewed as commercially viable. Part of this jects will bog down in confusion. Without a com- framework provided for the privatization of mitment to individual projects that Þt into the government assets at both the federal and state broader strategy private sponsors will be unable levels. Cutbacks in federal government funding to wade through the government approval put pressure on the states to run their govern- processes. ment enterprises and utilities efÞciently and to Negotiations over a take-or-pay contract, for consider selling assets. 24 Choices for EfÞcient Private Infrastructure Provision in East Asia

The federal government went out of its way mate that is now sufÞciently attractive and to facilitate private involvement in infrastruc- stable that investment banks and other insti- ture and the privatization of assets through a tutions are setting up private infrastructure range of incentives. It had no direct control over funds to channel long-term Þnance into how states took advantage of the changed envi- infrastructure projects. ronment, however, and each state approached ¥ A framework for involving the private sector the task differently and with different motives. in water has been developed in South As a result Australia has experienced a wide Australia that keeps rates under government range of outcomes with private infrastructure control but has the private sector managing since 1987, when the process Þrst gained the system. momentum: ¥ Negotiations over a take-or-pay contract for Involving the private sector in the power indus- an electricity generator at Loy Yang B in try. In 1991 the government of Victoria decided Victoria were drawn out and very expensive. to sell the unÞnished Loy Yang B power station ¥ Construction of a 600-megawatt power sta- and commenced negotiations with Mission tion in Collie in Western Australia was can- Energy, the entity Southern California Edison celed after lengthy negotiations with private uses to conduct business outside its traditional consortia. operations in the United States. Severe bud- ¥ Private toll roads were constructed in New getary difÞculties brought about by extensive South Wales and Victoria. losses sustained by its government-owned ¥ Water treatment facilities in New South bank, the State Bank of Victoria, and other pres- Wales and Victoria were constructed, and sures meant that the state government was more such projects are under consideration unable to fund completion of the power station. in South Australia. Partial sale of the unÞnished power station was ¥ A tunnel under Sydney Harbour was con- seen as the only way of completing construction. structed in a deal that appears to have been Selling Loy Yang B to a private operator and close to a disguised Þnancing transaction. ÒbenchmarkingÓ other generators against its Australia has also seen the development of a performance was expected to raise efÞciency range of clear policy structures that have and improve industrial relations at other gener- evolved as a result of this diverse experience: ators in the La Trobe Valley. In fact, industrial ¥ Following the difÞculties of the Loy Yang B relations did improve dramatically, and the negotiations, Victoria deregulated its power introduction of a private operator enabled the industry by separating and selling off gener- industry to revise consumer pricing to better ators and distributors. The competitive reßect costs. framework has been so successful that Sale of the plant was legally complex and Victoria has attracted a new range of long- expensive, and the scope for misunderstanding term private investors willing to fund the and suspicion was broad. The sale was com- electricity industry at very narrow margins pleted by a new state government, elected in and pay very high prices for assets. 1992, that accepted the basic approach of the pre- ¥ A national electricity grid is in train that will vious government although it allowed Mission lead to the competitive supply of electricity Energy to purchase 51 percent instead of the 40 across states. Third-party access arrange- percent offered by the previous government ments are being put in place to facilitate (box 2.1). development of a national gas market. The sale of Loy Yang B was completed while ¥ State government utilities will be brought the newly elected state government was in the under the authority of the national competi- initial stages of deregulating the electricity tion regulator, which will prevent them from industry, which could have involved the break- serving as revenue-raising devices for state ing up or privatization of the state-owned power governments and force them to compete. utility, the SECV. Some ßexibility in the take-or- ¥ Governments have created an investment cli- pay contract was necessary to allow for future Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 25

Box 2.1 Allocating risks in the sale of Loy Yang B Box 2.2 Breaking up the electricity industry in Victoria and creating a competitive market for electricity Loy Yang B is a 1,000-megawatt plant made up of two 500- megawatt units. The state government of Victoria offered for After the sale of Loy Yang B in December 1992 the Victorian sale a 51 percent share of a $2.4 billion asset. The authori- government revamped the electricity industry, which now ties had to recover the cost of the plant’s construction, and consists of the following components: bidding took place on the basis of the electricity tariff. The • Five competitive, independently operating gener- authorities entered into a thirty-three-year take-or-pay con- ating companies (three brown coal, one gas, and tract; financing was arranged by a consortium of institutions one hydro), two of which have been sold and led by two Australian banks. The take-or-pay contract three of which are being prepared for sale involved a capability charge to cover fixed costs and an • A publicly owned transmission company, Power energy charge to cover variable costs, such as coal and Net Victoria, which owns and maintains the high- water. The security of the financing rested on the perceived voltage grid security of the take-or-pay contract, and the banks examined • A power exchange, which uses the transmission that contract carefully. grid and which is responsible for the wholesale The state government utility, the State Electricity market arranging dispatch and system security. The Commission of Victoria (SECV), took on the construction power exchange is not an arm of the generators, risk of completing the power station. The SECV was able to and the wholesale price of electricity varies. lock in the electricity tariff for ten years by hedging its power • Five regionally based distribution businesses, price through interest rate swaps to cover changes to the which have an initial franchise (to be phased out by capability charge brought about by fluctuations in interest 2001) in respect of franchise customers but which rates. are free to contest (along with independent retail- Mission Energy reportedly incurred costs of about $A50 ers from other states) business within each other’s million negotiating the purchase. The costs of the sale to the region for nonfranchise customers. Under the cur- state of Victoria were estimated by the State Auditor- rent system nonfranchise customers are cus- General at $A86.7 million: tomers who use more than 750 megawatts a year and therefore are free to choose their distributor. Cost of sale of Loy Yang B to state government Eventually all customers will have the right to Amount choose their supplier. (in $A million) Costs to the SECV Legal and other costs 23.2 Forgone delayed settlement 7.6 investment. They chose not to do so, however, Stamp duty paid on behalf of Mission Energy 6.2 and the legislation effectively puts a fence Total cost to SECV 37.0 around Loy Yang B. The importance of this deci- Costs to government sion by the Victorian government was not lost on Forgone stamp duty 49.7 the industry or the Australian banks that had Total 86.7 fought so hard to obtain guarantees from the Note: $A1=$0.78. government covering the impact of deregula- Source: State Auditor-General estimates. tion in the Þnal stages of the negotiations. By its decision the Victorian government sig- deregulation, a development that concerned naled that it was more interested in maintaining Mission Energy and terriÞed the Australian a good investment climate in Victoria than over- banks. In the end, the contract was signed and riding the earlier agreement, even though it the sale was completed, although the contract meant compromising on its competitive objec- was lengthened considerably to build in ßexi- tives. With a large privatization program at stake bility. The Victorian Government eventually it was clear where the Victorian Government broke up the electricity industry and put a com- thought its real interests lay. petitive structure in place with industry speciÞc Having watched this experience, the legislation (box 2.2). The sale of Loy Yang B to Australian banks are now less insistent on state Mission Energy did not Þt into the competitive guarantees, realizing that at the end of the day structure subsequently established. By passing governments have considerable scope to act uni- legislation, the Victorian government could eas- laterally and that a governmentÕs commitment ily have changed the nature of Mission EnergyÕs to a policy framework is very important. 26 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 2.3 Mishandling award of the Collie power sta- Box 2.4 Letting the private sector manage a publicly tion contract owned water system in South Australia In 1989 the Western Australian government called for The South Australian government sought private sector par- worldwide expressions of interest in building a 600- ticipation in the water industry in order to improve the effi- megawatt project on the Collie coal fields. The Collie pro- ciency of the industry and to build a competitive water posal came from a plan drawn up in the 1970s as part of the industry in South Australia capable of winning contracts in long-term strategy of the vertically integrated public utility, East Asia. the State Electricity Commission (SEC). Forty-four firms The successful contractor, United Water, a consortium responded to the request for proposals and two final bid- of Compagnie Generale des Eaux, Thames Water, and ders—Asea Brown Boveri and a joint venture of Mitsubishi Kinhill Engineers of South Australia, committed itself to a 20 and Transfield, an Australian construction company—were percent cost reduction and to $A628 million exports to selected. overseas and interstate markets for the ten years beginning In March 1991 Mitsubishi/Transfield was awarded the in 1996. Under the terms of the 15.5-year contract, United contract and set about creating a build-own-operate project. Water manages, operates, and maintains the water and Westpac, an Australian bank, led the financing syndicate. wastewater system for Adelaide, a city of 1.2 million. The By April 1992 the first Collie proposal had fallen by the government continues to own the assets and sets prices to wayside, and Asea Brown Boveri (ABB) replaced customers. The government therefore continues to shoul- Transfield/Mitsubishi, with ANZ Bank leading the financing der the responsibility of setting prices in a way that ensures syndicate. In September 1992 ABB submitted a new pro- that water is used efficiently. posal that contained large cost increases and some condi- The state utility, South Australian Water, will continue to tions that were unacceptable to the government. In provide the full range of water and wastewater services to February 1993 a new state government was elected that the nonmetropolitan areas of South Australia it is in the continued to negotiate with ABB, with the power purchase process of having ten BOT plants constructed for this pur- agreement the main issue. Amid heated debate the new pose. United Water will manage the day-to-day operations government canceled the Collie project in July 1993. In its of the water system, put together and manage the capital place the government announced a plan for a 300-megawatt investment program, and make recommendations on how single unit power station that would be funded and owned the capital program should be financed. Financing the pro- by the SEC but operated by a private company. gram could involve new BOT schemes, but final decisions Cancellation of the original 600-megawatt Collie pro- will be made by the Minister and the state cabinet. ject left the private sponsors bitter, although the decision to allow ABB to build the 300-megawatt plant went some way to smoothing relations between ABB and the government. generating. The banking industry rejected the claim that the banks had been unwilling to assume their The difÞcult negotiations associated with the share of the risks, claiming that the cancellation sale of Loy Yang B did not lead to the establish- of Collie was not a failure of the infrastructure ment of simpler processes for the construction of industry but a failure for Australia. It called for the Collie project in Western Australia (box 2.3). greater transparency from government in the Unlike the Victorians, who concluded that it was decisionmaking and tendering process. important to establish a framework to guide pri- The cancellation of Collie and the difÞculties vate sector involvement, the West Australians in negotiating the Loy Yang B deal have led to a approached Collie as a one-time set of negotia- general realization that large privately owned tions. In the end the project was canceled. generators are difÞcult to incorporate into a ver- The original proposal was recognized as hav- tically integrated publicly owned electricity sys- ing been too large. In addition, Òthe Þnanciers tem. To involve the private sector, governments were quite naive in dealing with Government... need to be clear about what they are doing and [and] seemed to be unaware of the process of identify the relationship they want the private government and the Parliament,Ó according to generator to have with the public utility and the Western Australian Minister for Energy. The with customers. government was also critical of the escalating Outcomes in electricity have been quite dif- cost of the original contract and the structuring ferent in eastern and western Australia. In the of the electricity price, which kept prices high west cancellation of a build-own-operate until 2013, fourteen years after the plant started scheme appears to have entrenched the power of Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 27 the vertically integrated state utility. In the east entire water supply of a capital city to a private breaking up the state utility into distribution contractor and allow the private sector to bear and generating units and then selling them has the risk of achieving performance targets. been so successful that it has transformed the At this stage there is little interest in Australia stateÕs budgetary position and created a new in selling franchises or handing water charging industry structure with considerable potential over to the private sector. There is enormous for efÞciency and lower energy prices. The chal- interest in using the private sector to manage lenge will be to keep competitive disciplines on water assets and build and own water treatment the system and to prevent the distributors and facilities integrated into a broader public system. generators from colluding. Speedy development of a competitive national grid will be very Involving the private sector in the transport sec- important. The success of the Victorian model tor. The Sydney Harbour Tunnel, construction of has changed attitudes around the country and which began in 1988, was spurred by the federal the vertically integrated power utility appears to governmentÕs curbing of state borrowings. The be on the wane all over the country. tunnel accelerated the development of a private infrastructure industry in Australia and was Involving the private sector in the water indus- instrumental in ensuring that subsequent road try. The water industry has sought private capi- projects allocated some risk to the private sector tal both to provide the investment needed to and were commercial. Today long-term institu- extend and strengthen public networks and to tional investors Þnance private toll roads, which increase efÞciency by benchmarking of public are listed on the stock exchange. facilities against private sector plants. Private Because of scrutiny by the Auditor-General investment has taken the form of build-own- of New South Wales, the project is now seen as operate (BOO) and build-operate-transfer (BOT) a disguised Þnancing transaction in which the schemes, largely in New South Wales, Victoria, state bore all of the risks associated with trafÞc and nonmetropolitan South Australia. Most of ßow. The Auditor-General (1994) has, in fact, the schemes have been closer to disguised concluded that for accounting purposes the tun- Þnancing arrangements than commercial busi- nel is owned by the state government (box 2.5). nesses, and the Auditor-General of New South Several pivate toll roads have been con- Wales (1996) has suggested that the returns to structed in Sydney and Melbourne (box 2.6), but the private equity holders are greater than war- policymakers now have reservations about the ranted by the risk of the projects. The Prospect appropriateness of private sector involvement Water Filtration Plant, for example, is legally in this area. owned by the private sector, but it is constructed Concerns center on the difÞculty that the pri- on land owned by Sydney Water, it is dependent vate sector has in handling network riskÑa risk on a supply of bulk water from Sydney Water, that the government is best suited to handle and Sydney Water is virtually its only customer. because of its planning responsibilities. After The private sector is able to recover from Sydney almost a decade Australian governments at the Water the entire debt and equity capital of the state and federal level are starting to crystallize project in net present value terms, and the pri- their views on private involvement in trans- vate sectorÕs equity in the project is protected in portation. There is broad agreement that there the event of default. Public sector negotiators are important efÞciency gains from having the have gained more experience since the Prospect private sector bear construction risk and man- deal was signed, and recent projects have pro- age state-owned assets, and a number of states vided returns that are more compatible with the have developed imaginative and useful models. level of risk. One such model is for road maintenance. The The South Australian government has used New South Wales governmentÕs system of con- the private sector to increase efÞciency and tracting road maintenance, which is based on develop the water industry. It is the Þrst state achieving particular targets, is the Þrst compre- government to hand over management of the hensive system of its type in the world. 28 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 2.5 Disguising a financing transaction as a com- Box 2.6 Efficiency of private sector ownership of mercial project: The Sydney Harbour Tunnel toll roads: The M5 freeway in Sydney Hailed as a commercial private sector project designed to The M5 freeway in Sydney, which takes traffic from the relieve congestion on the Harbour Bridge when it com- southern freeway, is designed to eventually become part of menced in January 1988, the Sydney Harbour Tunnel ended an orbital freeway network that takes traffic around the air- up as a disguised financing transaction of the New South port, through the city, under the harbor, and to the North. Wales State government. The freeway comprises M5 Central, which is privately Finance for the tunnel was raised by the Sydney owned and was built first; M5 West, which was funded Harbour Tunnel Company, which issued bonds that were largely by taxpayers in New South Wales and is now oper- fully underwritten by the private sector. Responsibility for the ating; and M5 East, which is yet to be built but could be either bonds rests squarely with the state government, however, public or private. The owners of M5 Central have already and revenues from tunnel tolls go to reducing the govern- benefited from the building of M5 West and will benefit even ment’s liability for the tunnel bonds. For this reason, the more once M5 East opens. Auditor-General of New South Wales (1994) concluded The Auditor-General of New South Wales (1996) has that for accounting purposes, the tunnel is owned by the pointed out that exits from the publicly funded M5 West can- Roads and Traffic Authority, a government authority. The not be completed because of the adverse consequences for tunnel toll does not cover the interest on the bonds, and the the owners of M5 Central. He concludes that an urban toll deficiency is covered by the toll on the Harbour Bridge and, road is not designed to efficiently meet the reasonable needs in the first few years, by the state government. Under the of the motorist but is designed to capture tolls and concludes original contract the Sydney Harbour Tunnel Company, that “private sector ownership of toll roads is prima facie less which technically owns the tunnel, is entitled to a small efficient than public ownership.” return that is tied to its maintenance function. There is no Opinions differ widely on toll roads. Private toll roads effective return from operation of the tunnel. are considered most appropriate where restrictions need The project grew out of federal government restrictions not be put on alternative traffic flows and where there is less on state borrowing and the need to reduce congestion on network risk to the private project that the government has the Harbour Bridge. It sparked the development of some to cover. These conditions tend to be met on toll roads con- innovative long-term (twenty-five-year) financing techniques nected to bridges and tunnels. and helped create a new market for institutional investment in private infrastructure. Since the tunnel is effectively government owned, the which will improve toll revenue and trafÞc ßow state government will benefit from any increase in traffic vol- through the city to the airport and through the umes brought about by private investment in the Eastern Sydney Harbour Tunnel, which the government Distributor, which connects with the tunnel. effectively owns. The government is attracted to the idea of a private toll road because only private funding Contracts will be speciÞed in terms of the con- would allow the project to be built before the dition of the road assets over the term of the con- 2000 Olympics, and the cost of constructing the tract rather than in terms of the conventional road would have absorbed about 31 percent of measures of work, budgets, and speciÞc tasks. the stateÕs capital and maintenance budget for The New South Wales system holds out the roads, a heavy burden to Þnance (box 2.7). prospect of having the private sector bear much The main private rail project underway is the of the risk of managing the condition of the New Southern Railway, which will link roads. SydneyÕs extensive rail system to the airport in An interesting test of government commit- time for the 2000 Olympics. This will be a BOT ment to private sector involvement was the deci- project, but the state will still own the track. The sion to build the Eastern Distributor, which private consortium will own the stations. Most connects the center of Sydney to the airport, as a of the users will not be from the airport, but the private toll road. Construction of the Eastern airport trafÞc will pay a premium and will make Distributor involves tunneling under the city, the project economic. The siting of the stations which means that it is relatively easy to build toll was designed to improve the value of govern- booths without disrupting trafÞc ßows. The pro- ment-owned land. Preliminary scrutiny by the ject sponsors have agreed to make improve- Auditor-General suggests that this project may ments to the roads connecting to the city tunnel, be less disadvantageous to the government than Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 29

Box 2.7 Getting a better deal: The Eastern Distributor to the airport In August 1996 the government of New South Wales to be better structured than earlier toll road projects and pays announced that the Eastern Distributor linking Sydney to the more attention to network consequences. airport would be built as a private toll road. The deal appears Features of Eastern Distributor project

Feature Contrast with previous projects Government does not contribute to land or ancillary works • The Road Transport Authority (RTA) will be repaid for land • Government contributed $225 million to land acquisition acquisition costs and associated works for the M2 motorway. • RTA purchased land for M5 motorway; cost was converted into a land acquisition loan to be repaid by the owners of the M5. • Southern Cross Drive will be widened to six lanes and General Holmes Drive to eight lanes at no cost to the government; wider roads will be available to all road users, who need not use the northbound toll road. • Contractor will accept full risk of construction and traffic • Traffic usage of Harbour Tunnel is underwritten by the gov- usage. ernment, which provides a guaranteed revenue stream. Improvements to public transportation are not limited by the deal • Toll free access is available for government-owned buses providing public transport. • Development of other road or public transportation options is not constrained by the project. • Preferred proposal acknowledges that Eastern Distributor will be part of the principal north-south road corridor in this vicinity. • No renegotiation will take place if alternative public trans- • M2 contract calls for renegotiation port options are developed. • Bus services for local residents will be improved. Urban amenities will be improved by tunnel • Six-lane tunnel from Moore Park to north of William Street will reduce noise and visual impacts, removal of through traffic from streets will improve environment and amenity for local residents, and pedestrian black spot at Taylor Square will be eliminated. Toll will be collected in one direction only, and improvements will • Tolls are collected in both directions on the M2 and M5 be made to toll-free routes. motorways. earlier ones. governments that sold state enterprises that had previously been exempt from federal income tax Federal incentives for Þnancing private infra- but that lost their exemption when they were structure projects. The federal government did sold to the private sector. more to encourage private infrastructure than The problem caused by the inability of a pri- simply cut back on the ability of the states to bor- vate project to offset the losses created in the row and cut their revenue grants. It introduced early years against other forms of income for a range of incentives designed to overcome taxation purposes is a serious one. Australia has aspects of the Taxation Act that made it difÞcult strict rules governing the transferability of to Þnance private projects. Infrastructure bonds losses between companies, which has meant were introduced and development allowances that losses from a stand-alone project can be set were provided for select projects. The federal only against future income and not against cur- government also took steps to compensate state rent income in an associated company. Since 30 Choices for EfÞcient Private Infrastructure Provision in East Asia large infrastructure projects tend to incur losses ¥ It can help a public utility set prices that bet- in the early years and large proÞts in the out ter reßect costs. Reaction to an increase in tar- years, not being able to offset losses when they iffs is often more muted if the utility is occur has made Þnancing private infrastructure privately owned. projects more difÞcult and expensive. There is recognition that governments must Generalized transferability of tax losses know exactly what they are trying to achieve by would have been very expensive, however. involving the private sector and that they must Instead, the government allowed approved pro- exercise disciplined in achieving their goals. jects to issue infrastructure bonds. The interest This has not always been the case in Australia, paid on these bonds is nontaxable, which makes where some contracts were poorly structured. them attractive to tax-paying bodies and allows However, as governments have developed a the bonds to pay a signiÞcantly lower rate than clearer idea of what role the private sector they otherwise would. To prevent infrastructure should play, their capacity to negotiate tighter bonds from becoming a general subsidy, the and better contracts has increased. Consultants government does not allow a project to deduct to government have also played a pivotal role in the interest payments as a business cost, as building frameworks and overseeing negotia- would normally be the case. This means that tions. infrastructure bonds provide considerable assistance to a project in the early years, when it is Recognizing the different interests of making losses, and offsets this assistance in the different government agencies later years, when the project is making proÞts and cannot deduct interest as an expense. The Many different government agencies, each with net beneÞt to the project in present value terms different interests, are involved in infrastructure is positive. Infrastructure bonds have been projects. Recognizing these interests and estab- widely used in the Þnancing of toll roads. lishing clear-cut procedures for implementing projects is critical. Both public utilities and pri- Lessons learned from experience. As their expe- vate sponsors must deal with a multitude of rience has grown, Australian state governments government agencies. But the public utility is have developed clearer ideas about what role treated as an insider and is often an effective the private sector can and should play in the pro- operator within the government. In contrast, a vision of infrastructure. Where these ideas have private sponsor is usually treated as an outsider developed most clearly, so, too, has the commit- and lacks allies within the government. ment to put them into effect. There is now wide acceptance that the pri- The Þnance department vate sector can proved several important bene- Þts in the provision of infrastructure: The Þnance department seeks to minimize pub- ¥ It can generate investment that would be lic liabilities. If public funds are to be used, the delayed if funded publiclyÑor not provided Þnance department will want as little debt as at all. This can have immense beneÞts if inad- possible raised and it will want to see a revenue equate power, water, roads, and sewerage are stream to repay the debt. If the project is to be constraining growth. Private funding of funded by the private sector, the Þnance depart- infrastructure can free up government ment will not want the government to be drawn resources for high priority social programs, into government funding through guarantees to such as public health and education, which the project sponsors. could never be Þnanced privately. In Australia, as private infrastructure pro- ¥ It can produce large efÞciency gains if a pri- jects have been subjected to greater scrutiny, vate plant is introduced into a public indus- state treasurers have begun to require that inter- try that has not previously operated on est rate margins properly reßect any govern- commercial lines and that has poor staff rela- ment guarantees or commitments. This reßects tions. both the growing sophistication of Þnancial Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 31 markets, which have tended to see through dis- level (state, national, or international) responsi- guised Þnancing arrangements and attribute liability for the environment lies, however. bilities back to the government when the public sector is in fact carrying all the risk, and height- The land acquisition department ened public sensitivity about tolls and contract details. Land acquisition can be difÞcult, particularly if it is left to the private sponsors to purchase The industry department required parcels of land. The nineteen toll road projects currently out for private tender in The industry department seeks to maximize Indonesia require that the private contractor be opportunities for local industry, whether the responsible for land acquisition. Whether this project is publicly or privately funded. It will requirement hampers the projects remains to be expect a substantial proportion of the equip- seen. ment used in the project to be manufactured Many projects cannot proceed unless the locally and will want to see technology transfer government provides the land or is willing to and a commitment to export. Although the use its powers for compulsory acquisition. But industry department may be supportive of pri- the department responsible for compulsory land vate projects, however, private sponsors may acquisition will be reluctant to use its power to Þnd it difÞcult to comply with all the industry assist a private project. requirements, particularly if the department requires a high level of offset business. The public utility

The employment department The public utility will try to maintain its central role. If the regulatory function has traditionally The employment department seeks to maximize resided with the utility or been heavily inßu- opportunities for local employment. If skilled enced by it, the utility will resist change, even if personnel are required, it will expect them to be its resistance endangers new private invest- trained locally, not brought in from overseas. ment. In many cases the public utility will be the Most private sponsors can make their projects most difÞcult institution or agency to deal with, attractive to the employment ministry by offer- particularly if the utility believes that the private ing to train local residents to assume important sector is being involved as a disguised Þnancing positions created by the new project. One of the vehicle to get a project built. If the government unexpected beneÞts in Australia of replacing also believes the project is a disguised Þnancing state-owned enterprises with private Þrms has scheme, problems will inevitably arise, unless been the opening up of new career opportuni- the private sponsors of the project accept the role ties. the government assigns them. Public utilities become concerned when The environmental agencies change is proposed, and these concerns can make change difÞcult. For example, if contrac- The environmental agencies will want to mini- tual relations are to exist between the public util- mize the detrimental impact of projects on the ity and the private project, the public utility will environment. Given the long life of most infra- want to maintain maximum control, even if such structure projects, most investors are interested control raises the level of risk to the private pro- in minimizing the risk of having to make expen- ject. The utility will often have powerful allies in sive upgrades to environmental standards part this quest to retain control. It will suit the Þnance way through the life of a plant. department, for example, to have all guarantees The environmental agency can perform a provided by the utility rather than the govern- helpful role by ensuring that proposed projects ment. Retention of such control by the utility can meet environmental requirements. The agency weaken the private project if the Þnancial stand- can cause confusion if it is not clear at which ing of the utility is unclear, however. 32 Choices for EfÞcient Private Infrastructure Provision in East Asia

The workforce of the utility will also feel ities and authorities are functioning with some threatened if it suspects that the private project credibility. Cooperation between the ofÞcials is designed to benchmark more efÞcient levels of responsible for key public utilities and the spon- stafÞng. Workers and management of the public sors of private infrastructure is therefore essen- utility can be a powerful political force, particu- tial. larly if the utility has a large investment pro- Many public utilities and ofÞcials would like gram. In Australia in the 1980s, for example, the to take advantage of the expanding revenue head of the government-owned telecommunica- resulting from economic growth and to imple- tions company often warned cabinet ministers ment commercial pricing on their own. If poli- of the impact that a cutback in the agenciesÕ bor- cymakers are not going to fund public rowing program would have on phone connec- investment, they need to make this clear to the tions and investment in marginal seats held by public utilities by introducing a policy frame- the government in Parliament. work that deÞnes the role of the private sector. Without clear policy articulation there will be Federal/state issues ongoing confusion and resistance to change. Negotiations over take-or-pay or power con- In a federation each state or provincial govern- tracts should not be taken over entirely by pub- ment will want to bring investment and employ- lic utilities. The minister needs a team around ment to its region and will be distrustful of him or her whose experience is broader than that national guidelines. State and provincial gov- of the utility. While the governmentÕs negotiat- ernments will use their ability to withhold plan- ing team needs to understand the utilityÕs inter- ning approvals to leverage their interests. ests, it also needs to be able to put those interest Without coordination there is likely to be dupli- into a broader context. cation of approvals processes. If a project can be sited in any of a number of states, the project Resolving issues sponsor can use the resulting competition among states to negotiate a better deal. State Handling the competing pressures of private charges and taxes can be bid away in this infrastructure projects requires that ministers be process, and duplication of approval processes committed to private sector participation and diminished. put in place administrative arrangements that Federal/state relations can often be perplex- allow competing issues to be resolved. ing to private sponsors, who may be unsure about who has Þnal authority and what the real Coordinating government issues are. Matters can become very confused when one level of government assesses a project Private infrastructure projects will stall unless differently from another and takes policy action the government establishes organizational accordingly. This happened recently in structures to prevent government processes Australia when the previous federal govern- from overwhelming projects. Most countries try ment disallowed private toll roads from qualify- to deal with the complexity of the negotiations ing for infrastructure bonds. The new federal and the large number of government agencies government restored their eligibility. involved by establishing central coordinating Public utilities in East Asia are important agencies. In Malaysia the coordinating agency is bodies overseeing large and expanding invest- the Privatization Unit of the Economic Planning ment programs. In 1993 an estimated $70 billion Unit (EPU) in the Prime MinisterÕs OfÞce; in was spent on investment in the region, most of Australia the agency is the OfÞce of Asset Sales it publicly funded. This is quite different from in Canberra; in Indonesia the State Secretary the situation in South America, where the pub- Moerdiono coordinates the processes. The coor- lic utilities performed poorly before the recent dinating agency in Malaysia is particularly pow- round of privatizations. In many of the more erful, since it comprises the Technical successful East Asian economies the public util- Committee and the Financial Committee, which Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 33 evaluate and negotiate with the private Þrms able to make decisions on the rules, and the rules (Yaacob 1996). have to be accepted as Þxed. A properly functioning central agency can be Even when rules are established, however, useful if it brings all the agencies together and issues will arise that cannot be determined on ensures that issues are resolved; if the central the basis of Þxed rules. Some of these issues may agency is just another layer of authority without be contentious. But decisionmaking will be sim- the ability to deliver decisions from other agen- pliÞed by establishing rules in advance and cies, it will only add to frustration. An all-pow- leaving commercial judgments to the project erful central agency can lead to another range of sponsors. Ideally, the sector or regulatory frame- problems if it runs roughshod over other agen- work that the government devises to oversee the cies without resolving legitimate concerns. If industry will answer most of the questions; as this is done, negotiations can be reopened at time goes on, the process may require less and great cost to all parties. less scrutiny. After the initial investment in the The process will be most efÞcient if over time detailed framework, the government may well an agreed upon framework can evolve that Þnd that the process of selecting private infra- enables the following key issues to be structure projects becomes more and more addressed: straightforward. ¥ The relationship between the private facility Both the private sponsors and the govern- and the public utility and distribution system ment need to accept a measure of self-discipline; ¥ The tax treatment afforded private projects. both sides should avoid springing unexpected While individual tax rulings may be neces- new demands on each other once either party is sary, each project should not have to negoti- locked into the project. The temptation for ate its tax treatment separately. If taxation either party to engage in Òsequential ambushÓ arrangements are creating problems, they is real, but the long-run consequences heavily should be resolved for all infrastructure pro- outweigh any gains that might be extracted in jects. the short run. The government must recognize ¥ Arrangements for supporting local industry, that it will be seeking new private infrastructure which should be understood at the outset repeatedly and that a reputation for springing and left intact as the tender process proceeds. new demands on project sponsors or changing If local industry preference is part of the ten- the rules when it is very expensive to disengage der process, it should be transparent. will add to Þnancing costs in the future, as spon- ¥ Requirements for training, environment sors try to protect themselves against the poten- clearances, and immigration, which should tially higher cost of doing business. The private be understood at the outset. sponsor must recognize that a reputation for ¥ Authority over and responsibility for the backing out of commitments at the last minute, project, particularly if there is signiÞcant failing to deliver on promises, or making new opposition from certain agencies. demands will make it very difÞcult to secure If senior ministers are Þrm, rules can impose new business in the region. The last minute structure and prevent particular agencies from demand for government guarantees to cover constantly reopening matters and trying to construction risk in the Sydney Harbour tunnel reverse earlier decisions. Establishing a rule that project was difÞcult for the government to han- tenders should be evaluated on the basis of dle since by then it had no way of withdrawing world pricing of inputs would simplify dealings from the project. Governments can protect with the industry department, for example. If themselves by not committing themselves pub- local industry preference is to be built into the licly to a project until they have reached agree- process, a Þxed level of preference (say, 10 per- ment with the main project sponsors on key cent) can be prescribed. Formalizing this process issues. is preferable to having to make decisions about every potential domestic input. For rules to be Resolving federal/state disputes effective, however, senior ministers have to be 34 Choices for EfÞcient Private Infrastructure Provision in East Asia

In some countries, particularly those with strong the project from being held hostage at the state state or provincial governments, uncoordinated level. and possibly confrontational relationships In Australia experience has shown that in a between policymakers at various levels of gov- federal system in which the states have consid- ernment may cause problems. When state erable power, heavyhandedness is counterpro- administrations are strong the central govern- ductive. The federal government needs clear ment may feel that it is losing its ability to con- instruments it can use to enforce its policies, but trol the macro economy if many major at the end of the day there has to be a measure infrastructure projects remain outside its control. of cooperation. In Australia this cooperation has To regain control, the central authority will often come from regular formal high-level meetings announce guidelines governing projects. In between state and federal leaders, who have many cases this may make sense, since it is efÞ- managed to agree on a range of national priori- cient to have power, water, and transportation ties they are willing to support. The Council of conform to national guidelines rather than unco- Australian governments (COAG), a body set up ordinated state ones. (The Australian experience to deal with federal/state issues of national with six noncompatible state rail systems is a importance, meets regularly. case in point.) However, central guidelines can With national agreement has come a willing- cause problems if the coordination of state and ness to coordinate responses to infrastructure federal guidelines has not been thought through. projects, particularly on environmental issues, In countries such as China, where the rela- where effort has been made to avoid duplicating tionship between the center and the provinces is environmental impact studies. Federal programs still evolving, private sponsors of infrastructure that provide for taxation incentives, such as infra- projects often Þnd themselves entangled in com- structure bonds and investment allowances for plex and overlapping administrative arrange- eligible infrastructure projects, have also encour- ments. Individual states and cities can have aged the states to coordinate their processes with considerable power to raise revenue and fund federal processes in order to make infrastructure particular projects, but the central authority usu- projects eligible for federal incentives. As with ally has sufÞcient power over taxation or most federal systems, there is scope for national exchange control to exert its authority if it coordination, but it is normally the federal gov- wishes to do so. ernment that has to pay to achieve it. Some promoters of private infrastructure If there is a lesson to be drawn from the have tried to minimize the difÞculties that can Australian experience with federal/state issues, occur by establishing direct commercial links it is that the federal taxation power is very with cities and states (box 2.8). While such a strat- important in building national responses. This egy may work for certain projects, particularly lesson may have some relevance for countries those that are commercial and not dependent on such as China, where national/provincial rela- multilateral or aid agencies, it can add another tions are still evolving. The fact that Beijing is element of risk to the project if the sponsor does building a national taxation base to replace the not fully understand the relationship with the income it received from public enterprises will center. Without central government involvement change the relationship between the center and and support there is also greater risk associated the provinces and may result in a steady increase with enforcing contract provisions. in BeijingÕs authority over the provinces. Regardless of a projectÕs ability to deal directly with a city or state, there may well be a Obtaining the best deal need for the central authorities to control behavior at the state level, especially when it comes to East Asian countries face tremendous opportu- land acquisition and the provision of state ser- nities for harnessing the private sector. Private vices to the project. The central authorities may sector investment in infrastructure can remove have to use their taxation powers and controls bottlenecks, improve economic growth, and on borrowing and foreign exchange to prevent reduce the social problems brought on by inad- Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 35

Box 2.8 Forging links with cities: The China Water Company The China Water Company is a recently formed developer and over a specified contract period. The project is expected to be investor in water supply, wastewater treatment, and water- completed within eighteen months and will supply 150,000 related infrastructure in China established by AIDC Ltd., an cubic meters of water a day to the local population. The com- Australian institutional investor. AIDC’s equity holders are nei- pany has also identified a number of other potential projects. ther suppliers nor operators in the water industry but long- Chinese cities cannot borrow, but their authorities can, term investors from Hong Kong and institutional investors of although they usually do not have the standing to do so. The the Australian and Singapore governments. The company has China Water Company identifies an income stream; negotiates initial shareholder funds of $30 million, shared equally between a contract with the water authority and the city, possibly involv- the AIDC, Hong Kong Land, and Hong Lim Investments, a sub- ing a subsidy from the city; satisfies itself of the security of the sidiary of the investment holding company of the Singapore arrangements; and builds the facility. government. Chinese cities appear to see an advantage in deal- AIDC has found that avoiding aid agencies and multilateral ing with long-term investors rather than with operators or sup- lending institutions has made decisionmaking easier, and it has pliers who are seen as often being more concerned with found the Chinese legal structure better than expected. The short-run returns. company has scope to expand, as many Chinese cities now AIDC is building a commercial business with individual have the income and wealth to finance water infrastructure on Chinese cities and does not deal with concessional lending insti- a commercial basis. It is estimated that to alleviate shortages tutions or multilateral bodies. The company uses appropriate China will need to build more than 230 new water plants sim- local technology where possible and buys its water expertise ilar in size to the Shenyang project over the next five years. on the market. It has entered into a joint venture with the Beijing’s restriction that the private sector cannot own the Shenyang Water Supply General Company, a government- water distribution system means that China’s cities will be keen owned water utility company in Shenyang city, the capital of to use private capital to fund water treatment facilities to free Liaoning province. The $25 million joint venture involves the up resources to improve distribution. construction, operation, and management of water facilities equate water, sewerage, transportation and given to how competitive forms of transporta- power. The private sector is keen to invest and tion will interact. Future public investment in the will accept narrow margins if private Þrms are network, which will affect the revenue of the toll forced to compete. To negotiate effectively with road, also needs to be reßected in the negotia- private Þrms however, government agencies tions. A new private water treatment plant needs may need to acquire new skills. Multilateral to be coordinated with future public investment bodies and multicountry forums can help. in distribution. A new private power generator requires investment in high-voltage and low- Scrutinizing projects voltage distribution facilities to make best use of the private project. Future investment by the The potential gains from shrewd contract nego- public sector made necessary by a private project tiation are enormous in twenty- to thirty-year should be reßected in the negotiations with the take-or-pay contracts. These contracts are com- private sponsors, particularly if the private plex, legally dense documents the main purpose equity holders will beneÞt from future public of which is to provide sufÞcient security to an investment. For example, a private toll road may income ßow that Þnanciers will lend to the pro- be very ÒbankableÓ because of its ability to raise ject. Both the governments and the project spon- a large revenue stream from motorists. But if it is sor and Þnanciers will have expert advisors connecting two toll-free public freeways, legiti- review the contract. These advisers will be very mate questions can be raised as to whether the busy during negotiations (although the fact that project is earning an income stream from the new their compensation depends on the amount of investment or from the existing investment in the time spent suggests that in some cases negotia- two public freeways. In such situations closer tions may be prolonged unnecessarily). analysis might suggest that the public sector join While governments need advice on the com- the two freeways. Even if the private project rep- plexity of the contracts, they also need the exper- resents a disguised Þnancing arrangement and tise to evaluate the broader ramiÞcations of the the public sector beneÞts from commercial wind- project. With toll roads consideration has to be falls, all the costs to the public sector associated 36 Choices for EfÞcient Private Infrastructure Provision in East Asia with the private project should be considered. costs involved in the sale of Loy Yang B. Governments sometimes feel more comfort- Partly as a result of the work of the state able dealing with a business person or company Auditor-General, the current government in with whom they have dealt in the past. New South Wales announced a formal policy Negotiations with such a person or company entitled ÒGuidelines on Private Sector can often be more straightforward and speedy Participation in Infrastructure Provision.Ó The since there is a greater measure of trust and guidelines cover the calling of tenders and the mutual understanding between the parties. methods of selecting proposals. Because they are perceived to have a lower level The Auditor-General does not have the of political risk such Òfavored-sonÓ projects can power to scrutinize all documents, particularly sometimes be Þnanced relatively more simply. documents held by the private sector, many of In the long run, however, governments are likely which are commercially sensitive. The extent of to obtain better terms if they develop a frame- the Auditor-GeneralÕs powers over private work within which a wide range of companies infrastructure is still being debated in Australia, can bid on an arms length basis. and some balance will need to be struck between Governments are at a disadvantage when a protecting commercially sensitive documents of private promoter devises a project and then pro- private companies and taxpayersÕ right to know ceeds to market it to the authorities, since the what is being done in their name. government is forced to depend on the expertise of the promoter to evaluate the project. Where The role of the regulatory authority proposed projects have been announced by the government and have not been subject to com- What happens if performance turns out to be petitive tenderingÑas in the Sydney Harbour radically different from what the Þnancial mod- Tunnel projectÑor crucial Þnancial issues have eling suggested? If the project generates more been developed in a posttender arrangement, revenue than expectedÑbecause of greater pro- the government faces increased risks. Despite ductivity or lower costsÑthere will be political these drawbacks the Malaysian authorities have pressure to recoup some of the windfall gains for deliberately avoided competitive tendering. The consumers. If rates of return are lower than government selects private companies with expected, the project owners will want to revisit which it negotiates, and the private sector is the pricing arrangements, something that gov- encouraged to propose particular projects for ernments usually resist. privatization. Contracts in Malaysia have never In industrial economies governments estab- been regarded as immutable, however, and the lish independent regulators to deal with such government can renegotiate aspects that are situations. This would be done either by review- unsatisfactory (Yaacob 1996). ing rates of return or by reviewing CPI-X for- mulae at periodic intervals to keep a balance Project review: the role of the auditor between the interests of the consumers and the private investors. In Australia formalized review of the govern- As East Asian economies develop and the ment contracts with the private sector has been private sector plays a larger role in the provision left largely to the State Auditor-GeneralÕs OfÞce, of infrastructure, the need will grow to require which audits projects and makes the Þndings the review of tariffs in order to avoid abuse of known to state parliaments. State Auditors- market power. Arbitrary government discretion General are statutory ofÞceholders, and to adjust tariffs after contracts have been signed although they are appointed by executive gov- would make private infrastructure projects ernment their authority comes from Parliament. more difÞcult to Þnance on a project Þnance It is from the Auditors-General in New South basis. Establishing a review process with Wales and Victoria that the public knows so accepted guidelines and methods of operation much about the Sydney Harbour Tunnel, the could reduce uncertainty and facilitate new pri- tollways, the water treatment works, and the vate investment. In many jurisdictions the Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 37

Box 2.9 Promoting competition and investment in gas with a third-party access code As part of the drive to build a competitive national market for every five years in order to allow questions of excess or inad- electricity and gas, state and federal leaders in Australia agreed equate profits to be addressed. Not all issues would be subject in mid-1995 to create the Gas Reform Task Force. The Task to review, however. Structural issues would be set in stone to Force has set about developing a national code for third-party give certainty to the project but market variable issues, such as access to all pipelines. It covers both transmission and distribu- demand, would be reviewed. This provision also enables the tion systems. Federal and state representatives, regulatory CPI-X formula to be reconsidered every five years. agencies, the gas industry, and major consumers have all been The model strikes a reasonable balance between the need involved. for certainty and the difficulties associated with locking up the The code will determine an access reference tariff, which reference price for at least twenty years. The code reduces risk will be based on a fair rate of return on assets. This will require and is welcomed by investors in the gas industry and new financial modeling and careful valuation of assets. Effort has investors seeking to compete by building new pipelines. The been made to provide incentives for discounts and to avoid code will increase competition, but it will not get in the way of passing on costs if the pipeline is not fully utilized. The natural the original negotiations that underpinned the financing of the monopoly elements of the gas industry are to be structurally pipeline, since it will apply only to third-party users after the separated, and the reference tariff will be adjusted by a CPI-X foundation users and suppliers have signed contracts that make formula. the pipeline viable. Provision is also made for review of the reference tariff authorities retain the right to reopen contracts integrated publicly owned electricity industry. that prove to have undesirable consequences. In Commencement of the Paiton Power Malaysia, for example, the authorities have Generating Complex in Indonesia is likely to made it clear that contracts are not immutable, lead to similar pressures. Already other private and contracts have been renegotiated. Such a electricity projects are progressing on the basis system works in Malaysia because there is close of the Paiton contract, saving money and effort communication between the government and by simplifying the negotiating process. The fact private investors and because investors have that Paiton debt is now rated and trading in New been allowed to earn attractive rates of return. In York as investment-grade paper represents a the power sector Independent Power Producers major step forward. As all parties gain experi- (IPPs) earn rates of return of 18Ð19 percent, and ence, then new regulatory arrangements will concession contracts for road projects are need to be put in place to bring greater certainty designed to provide investors with a return of to both existing investors and new entrants 14Ð15 percent. However, East Asian govern- while promoting competition and efÞciency. ments may Þnd it attractive to formalize infor- Victoria has had great success with a pricing mal review processes as contracts take on model based on splitting off the generators from greater weight and they seek to strike even more the distribution function and forcing the gener- competitive deals with private investors. ators to compete on pricing in a central pool. In Australia the current negotiations over a Elements of such an approach could be usefully third-party access code for national gas introduced elsewhere. Malaysia has taken steps pipelines illustrate how regulatory arrange- in this direction by selling off a share in Tenaga ments that open up new markets and provide Nasional, previously the monopoly supplier of for a fair rate of return on assets and periodic electricity in Malaysia. Five independent power review can reduce uncertainty, encourage com- producers have been allowed to supply electric- petition, and make private investment more ity to Tenaga, with a separate regulatory agency attractive (box 2.9). set up to ensure fair pricing, prevent anticom- The Þrst private project can act as a catalyst petitive behavior, check prudent investment, to regulatory change. The sale of Loy Yang B and ensure safety in the industry. As well as cor- broke the mold in Victoria, and although it did poratizing the old monopoly supplier and mak- not Þt into any competitive model, it did force ing it more responsive to market forces, the the government to think through the implica- changes have brought new entities into the sys- tions of a lone private supplier in a vertically tem that over time will serve as benchmarks 38 Choices for EfÞcient Private Infrastructure Provision in East Asia against which efÞciency can be measured. model rather than use a noncustomized model or Pressure will continue to build to make tariffs depend on the model prepared by the project competitive. As the system evolves and the sponsor. Having the capacity to build a Þnancial independents become more signiÞcant, this model and assess models built by others requires pressure is likely to lead to further regulatory skills that all governments should possess. reform. Malaysia may be inßuenced by the It is clear that the public sector in Australia windfall that Victoria gained from selling assets has been learning from its mistakes and has been and decide that it, too, wants to reap some of the developing new skills. It is also clear, however, beneÞts that can come from continuing to dereg- that to a large extent different infrastructure sec- ulate their system and selling off generation and tors have failed to learn from the mistakes of distribution assets. other sectors. More can be done so that experience gained in one area of government is quickly Improving public sector technical and negotiating passed on to other areas and so that experience skills gained in one country in the region can be transferred to other countries. Advisers with a broad Public servants often lack technical and negoti- understanding of policy are essential to comple- ating skills. The Auditor-General of New South ment the lawyers and advisers. Outside consul- Wales (1996) has highlighted the question of the tants to the Victorian government, including capacity of the public sector to negotiate accept- Troughton Swier and Associates and Credit able arrangements with the private sector: Suisse First Boston, have been at the heart of electricity reform there. Advisers can be trained The public sector typically does not have or hired, and advisers and ofÞcials to could the prospect of commercial failure that rotate among East Asian countries. helps to motivate the private sector. And it has not trained its public service to The advantages of a framework develop and assess what are often con- ceptually difÞcult arrangements. The Australian experience reveals that a frame- Moreover, the government does not work that sets out how private infrastructure reward its senior ofÞcers in the same projects will operate strengthens the hand of way to the same extent as does the pri- public sector negotiators, particularly if the vate sector. It would thus be surprising framework promotes competition among the if the governmentÕs senior executive had private sector bidders. Understanding the oper- the necessary skills to negotiate a bal- ating environment reduces uncertainty, which anced deal with the private sector. And will enable the government to negotiate nar- if senior executives in the government rower margins with private promoters. If the sector have these skills, they must be government structures its framework to pro- tempted to seek employment with the mote competition, it can gain an additional private sector which actually pays for advantage by forcing private sector sponsors these skills. and investors to bid against each other to further compress margins without exposing the gov- Contract negotiations are normally based on ernment or the community to additional liabili- Þnancial modeling, which attempts to deter- ties or costs. mine the rate of return generated by particular There is currently no shortage of private tariff structures. The task for the government equity willing to invest in infrastructure projects and project negotiating teams is to arrive at a in East Asia. Large infrastructure funds inter- rate of return and a tariff that look reasonable to ested in long-term investment are located in both parties and are acceptable to the Þnanciers. Hong Kong and elsewhere, and U.S. utilities are The Þnancial modeling used by the parties is keen to invest in East Asian infrastructure pro- central to the negotiations, and it is essential that jects as a way of lifting their overall earnings the government be in a position to build its own rate, the domestic part of which is held down by Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 39

Table 2.1 Proceeds from the sale of the distribution businesses and generators in Victoria (millions of Australian dollars) United Energy Limited Solaris Power Eastern Energy Powercorp Australia Citipower Limited Yallourn Hazelwood Sale date August 95 October 95 November 95 November 95 November 95 March 96 August 96 Book value 944 490 971 1204 693 1,537 700 Gross proceeds 1,553 950 2,080 2,150 1,575 2,428 2,350

Note: United Energy Limited, Solaris Power, Eastern Energy, Powercorp Australia, and Citipower Limited are distribution businesses. Yallourn and Hazelwood are power stations. Source: regulation in the United States. International ators were sold sequentially during the twelve companies that supply equipment for infra- months before August 1996. The tendering structure projects, particularly power projects, process raised $A950 millionÐ$A2.4 billion for are also keen to become equity partners, and each business, for a total of $A13.1 billion from energy suppliers want to participate in exchange the Þve distribution businesses and two genera- for long-term contracts. National utility compa- tors (table 2.1). At the time of the tendering nies, such as ElectricitŽ de France, are also keen process, these assets had a book value of about to invest as part of a national strategy. All these $A6.5 billion. companies recognize that East Asia is the fastest- The bidders were prepared to accept consid- growing area in the world, that growth erable commercial risk once they felt the policy prospects are poor in Europe and elsewhere, and structure was secure. The distribution busi- that the margins on their traditional businesses nesses were sold without guarantees, with the are low. All have come to the conclusion that understanding that the exclusivity of their fran- infrastructure investment in East Asia is one chise was not watertight and that franchise cus- way of pursuing their corporate goals and tomers who could not choose their suppliers increasing earnings. These companies are also would be protected by a CPI-X regime that attracted to spreading their investments across would set maximum uniform retail tariffs. By countries to minimize risk so that the investment 2001 all customers would be able to choose interest is not concentrated in particular coun- whom they purchased electricity from, and they tries but is spread across the region. would be able to choose from a list of indepen- At the same time, Asian capital markets are dent retailers that would include retailers from developing rapidly, and there is growing scope other states. Choice would be phased in, with for countries to Þnance private projects domes- the largest consumers having the opportunity to tically without recourse to foreign capital. A choose Þrst. developing domestic capital market is very In reality, each distribution area was rela- important because it enables long-term invest- tively secure, but the distributors would have to ment and savings to be channeled into private compete for their larger customers and could not infrastructure and allows the projects to be treat their smaller customers too casually. What Þnanced in domestic currency, thereby remov- made the distribution businesses attractive to ing exchange rate risk from what are essentially the bidders was the fact that despite the uncer- domestic investments. The rapid development tainty, the new arrangements provided the of Australian capital markets since they were opportunity to introduce new technology and to deregulated in the 1980s has been very impor- retain the gains that might come from produc- tant in helping to Þnance private infrastructure. tivity improvements and cost reductions. What Given the strategic concerns motivating was offered provided enough security and busi- many potential investors, governments have ness opportunity to make the distribution busi- scope to extract premiums. In Victoria the state ness attractive assets. The generators were sold government created a framework that provided without guarantees, with only the prospect of for the separation of the generators from the dis- selling electricity in a wholesale market in which tributors, but it also provided for the sale of the generators in other states with excess capacity regionally based distribution businesses and the would compete. generators. The Þve distributors and two gener- A wider range of equity holders were 40 Choices for EfÞcient Private Infrastructure Provision in East Asia involved in the various consortia, including U.S. Today the Þnancing task has become so large and U.K. power utilities and Australian super- that multilateral Þnancial institutions can play annuation funds. One of the reasons such high no more than a small role in Þnancing. They can, prices were realized was that funds managers however, play an important role in strengthen- believed that the electricity industry in Victoria ing government institutions and their ofÞcials was an attractive place to invest. This was the by providing training and by funding expert turning point and underscores why the sale advice. In this way, governments can deal more process was so different from the sale process for effectively with project sponsors to everyoneÕs Loy Yang B. Loy Yang B needed government advantage. guarantees and took an extended period of Multilateral institutions can also assist some intense negotiations. The Þve distributors and countries with the tendering process by provid- two generators were sold within twelve months ing advice and, if asked, assisting in the selection without guarantees. The difference was the process itself. This role might be helpful in coun- framework and the fact that the distributors had tries that are not accustomed to managing large a wider range of commercial opportunities international tendering processes on an arms because they sold directly to customers, unlike length basis. Participation by a multilateral Loy Yang B whose output was sold on a take-or- lending institution might spread the ßow of pay basis to the wholesale pool. The fact that a information and help bring the expectations of national electricity grid and a competitive mar- all parties into line. ket for electricity will be functioning within the The Asia-PaciÞc Economic Cooperation next few years has also added new commercial (APEC) Energy Working Group, which com- opportunities (see box 2.10 for an example of a prises the United States, Japan, Canada, sale under a competitive and stable market Australia, and the developing economies of East framework). Asia, has been active building regional coopera- The net result of these sales was that the state tion on energy matters. APEC brings a useful budgetary position was transformed and the perspective to such issues as trade liberalization, state gained new budgetary ßexibility. standards, and infrastructure. It provides the East Asian countries could conclude from leaders of the United States, Japan, and China this that they, too, could extract competitive with the opportunity to develop a common prices from the private sector if they established sense of purpose in a region in which the three frameworks that provide less than exclusive powers have much at stake in building a creative franchises but allow direct sales to customers and practical relationship. and genuine commercial opportunities. In APEC Energy Ministers met in Sydney for exchange the private sector would accept mech- the Þrst time in August 1996, when they anisms to protect customers from unfair trading. endorsed a work program that will strengthen There need be no government guarantees if in regional cooperation by, among other things, the process of establishing the framework, the facilitating the seconding. of regulators and Þnancial position of the various public utilities other trained personnel among member could be adequately scrutinized. If assets were economies. APEC also has the potential to speed also sold, East Asian governments could also development of sectoral and regulatory frame- Þnd their budgetary position improved, with works for energy. Its main strength, however, it greater scope to channel resources into high pri- is the only vehicle through which a number of ority areas. important multilateral issues, including environmental issues, standardization of energy The role of multilateral Þnancial institutions equipment, and security of energy supply, can be hammered out. Multilateral Þnancial institutions have tradi- Environmental issues in East Asia need to be tionally played an important role in the provi- addressed on a multilateral basis. Without sion of infrastructure in East Asia, providing agreement among nations, individual countries Þnance, soft loans, and technical assistance. may feel free to water down environmental con- Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 41

Box 2.10 Fetching top dollar when a competitive and stable market framework is established: The sale of Hazelwood Hazelwood Power Corporation operates an integrated brown tricity market was deregulated. In fact, the old State Electricity coal mine and a 1,600-megawatt power station located in the Commission of Victoria was set to close Hazelwood. La Trobe Valley. The Corporation was sold August 4, 1996, for Hazelwood’s main attraction is that it should be able to oper- $A2.35 billion. It had a book value of about $A700 million, rev- ate as a low-cost base load facility selling into New South Wales enue of $A255 million in 1995–96, and earnings before inter- and South Australia once the national grid is established. est, tax and depreciation of $A115 million. Revenues were However, it will face fierce competition from New South Wales expected to decline over the next few years, pending the full and Victorian suppliers, who collectively have excess capacity. operation of the national market for electricity. The sale underlined that the market will pay a high pre- The corporation was bought by the Hazelwood Power mium for a commercial opportunity once a competitive and Partnership, a consortium comprising Britain’s largest electric- stable market framework is established. The high price was ity producer, National Power (52 percent), U.S. power com- achieved despite the government’s refusal to allow a major panies Destec (20 percent) and PacificCorp (19.9 percent), and equity holder in the Yallourn power station, U.K.-based the Commonwealth Bank and its funds arm (8 percent). Powergen, and a member of one of the losing bidders to have The high price paid astounded the market. Hazelwood is a degree of influence over Hazelwood’s management. a thirty-year-old plant, which many observers believed would Powergen withdrew from the consortia. be uncompetitive and would have to close once Victoria’s elec- trols in a bid to gain a competitive advantage. malize arrangements that previously could be With the environmental consequences of one left unspeciÞed when the system was entirely countryÕs standards likely to affect other coun- publicly owned. Learning to develop new sys- tries, there needs to be a venue in which these tems is not straightforward, and governments issues can be resolved. There may, in fact, be the frequently make mistakes along the way. But making of an agreement under which various governments learn from their mistakes. countries would provide assistance with new The Australian experience is similar to that of cleaner technology and cleaner coal that would many countries in East Asia. Initially, the stimu- beneÞt all concerned. APEC has the potential to lus for private involvement in infrastructure build the conÞdence and mutual understanding came from the need to invest despite tight bud- necessary to make such agreements possible. get constraints, and investments in transporta- The question of the security of energy supply tion, water, and power projects were little more is at the heart of many investment decisions, and than disguised Þnancing transactions designed coordination of electricity generating speciÞca- to get around budget funding problems. This tions has the potential to save more than $A10 phase also saw drawn out negotiations and the billion, according to APEC. The fact that coun- cancellation of projects. Although the private tries such as Indonesia and Australia, with their projects expanded supply, there was a feeling large energy resources, belong to APEC pro- that governments could have negotiated better vides scope for further progress on this issue. deals. In Australia transactions have been left Conclusion largely in the hands of state governments. Progress has been fastest in those sectors in Involving the private sector in the provision of which governments have tried to carve out a infrastructure opens up a wide range of oppor- legitimate role for the private sector. In the state tunities. With private sector funds governments of Victoria, for example, the breaking up and pri- can make essential infrastructure investments vatization of transmission, generation, and dis- even if they have limited scope to borrow or tribution assets has transformed that stateÕs raise revenue. But to attract private sector inter- budget position and has created a much more est and ensure that the state gets good value out competitive and responsive industry. of the private sector, governments have to Transportation has experienced a less radical develop sophisticated processes and acquire transformation, and doubts over the desirability sophisticated skills. Private investment in infra- of private toll roads remain. But states have structure forces governments to identify and for- improved their ability to extract competitive 42 Choices for EfÞcient Private Infrastructure Provision in East Asia bids from the private sector. State Auditors- be Þnanced in domestic currencies. Only General have brought public scrutiny to a num- when institutional investors are attracted to ber of projects, strengthening the hand of projects can governments negotiate nar- government and narrowing margins. States rower margins from private sponsors. have improved their ability to work closely with Expanding private infrastructure and a a number of potential contractors and have developing domestic capital market seem to developed techniques to extract better deals. go together. The fact that equity holders in a number of listed ¥ Private investor interest in infrastructure is toll roads have done well has encouraged a high, and private sponsors of projects will range of new institutional investors, which has accept considerable commercial risk in further strengthened the hand of governments. exchange for commercial opportunity if they Private water projects have developed believe the policy framework is stable. steadily, and they, too, have beneÞted from pub- Governments can reap large returns by lic scrutiny and the growing number of private developing a detailed framework that sets infrastructure funds. It is likely that the private out clearly the role of the private sector. sector will provide an important share of new ¥ If governments achieve the right balance investment in water treatment in the future, between security of return and commercial although there currently appears to be little inter- risk, private sponsors will accept competi- est in selling concessions or exclusive franchises. tion without government guarantees. OfÞcials are still digesting the full implica- ¥ There is a role for regulatory oversight, tions of the recent experience, although some which can encourage competition, reduce measure of consensus has occurred. Many now uncertainty, and encourage new investment. recognize the beneÞts of setting up a competi- Regulatory oversight is particularly impor- tive framework and forcing private investors to tant in the power industry. bid against one another. There also appears to be ¥ Even if the major objective in involving the agreement that competition and private owner- private sector in infrastructure is to increase ship in the power industry can free up budget budget ßexibility, governments can still resources and improve efÞciency. Better deals negotiate narrower margins by negotiating can now be secured in transportation and water, with several project sponsors and increasing although for many the main attraction of private public scrutiny of negotiated deals. investment remains budget ßexibility. Private infrastructure promotes efÞciency References because it allows private investors to design and organize investment to minimize ongoing costs. Auditor-General New South Wales. 1994. ÒRoad Private investors are less likely overengineer to Transport Authority: Audit of Infrastructure Projects.Ó New South Wales, Australia. plants or invest where risk is too high. BeneÞts _____. 1996. ÒFinancing Infrastructure: Private Profits on this score are likely to be particularly impor- from Public Losses.Ó Paper presented to the Public tant where the design of the plant has a large Accounts Committee, Parliament of New South bearing on the cost of ongoing operations and Wales, July 31. maintenance. World Bank. 1995. ÒInfrastructure Development in East Asia and Pacific: Towards a New Public-Private What implications for East Asia can be Partnership.Ó Washington, D.C.: World Bank. drawn from the Australian experience? Yaacob, Yahya. 1996. ÒContracting for Private Provision ¥ An innovative and ßexible domestic Þnan- of Infrastructure: The Malaysian Experience.Ó Paper cial market is important. Most private infra- delivered at World Bank Conference, September 24, structure projects are domestic and need to Jakarta. 3 Contracting for Private Provision of Infrastructure: The Malaysian Experience

Yahya Yaacob and G. Naidu

ntil just over a decade ago the provision tion in the economy led to a huge increase in the of infrastructure in Malaysia was almost size of the public sector relative to the economy: Uentirely the public sectorÕs responsibil- the public sector grew from about 29 percent of ity. Infrastructure services were considered far GNP in the 1970s to a peak of about 58 percent too important to be left to the private sector. And in 1981. Public enterprises proliferated. the Malaysian government, like many others, With the large government presence in the presumed that the technology and economics of economy, the public sector deÞcit grew, leading infrastructure precluded any substantial role for to a sharp increase in domestic and external bor- the private sector. Because of natural monopo- rowing. External debt more than quadrupled lies, economies of scale, and externalities in the between 1980 and 1985. Compounding this, the production and distribution of infrastructure international recession in the 1980s dampened services, infrastructure was considered more MalaysiaÕs export earnings. The looming eco- suitable for public provision than for private. nomic crisis culminated in a negative growth In the mid-1980s the Malaysian government rate in 1985, the Þrst since independence in 1957. initiated a program of economic liberalization By the late 1970s it was already apparent that and deregulation that included a comprehensive government revenues could not keep pace with privatization policy. The policy entailed down- the growing expenditures. It was these circum- sizing the public sector while expanding oppor- stances that prompted the governmentÕs policy tunities for the private sector. In infrastructure changes. the opportunities for private sector participation The shift in strategy from public-sector-led in areas previously the exclusive domain of the growth to private-sector-Þnanced development government have expanded considerablyÑnot began in 1983, when the prime minister only through the sale of equity in state enter- announced a national policy relating to the con- prises but also through privately Þnanced devel- cept of ÒMalaysia Incorporated.Ó This concept opment of new services and facilities. sees the country as a corporate entity in which the government provides the enabling environ- A shift toward private provision of mentÑinfrastructure, deregulation, liberaliza- infrastructure tion, and macroeconomic managementÑand the private sector serves as the main engine of The privatization policy had its origins in the growth. This policy marked the beginning of macroeconomic problems Malaysia faced in the MalaysiaÕs ambitious program of privatization. early to mid-1980s. Many of these problems The government set out its rationale for privati- were, rightly or wrongly, attributed to the gov- zation in Guidelines on Privatisation (Malaysia, ernmentÕs increasing involvement in the econ- Economic Planning Unit 1985). Implementation omy, largely in pursuit of the objectives of the of the policy is guided by the Privatisation New Economic Policy. This extensive interven- Masterplan, adopted in 1991 (Malaysia 1991a).

43 44 Choices for EfÞcient Private Infrastructure Provision in East Asia

The governmentÕs commitment to expanding that want to develop or operate infrastructure the private sectorÕs role in the economy is reit- in Malaysia need government sanction, in the erated explicitly in its Second Outline form of a contractual arrangement with the Perspective Plan (Malaysia 1991b). The Seventh government. Contracting between the public Malaysian Plan (1996Ð2000) conÞrms that pri- and private sectors in Malaysia for infrastruc- vatization will be an important means of ture provision, operation, and maintenance has achieving the governmentÕs development taken various forms, the main ones being leases objectives (Malaysia n.d.). Infrastructure is at and concession contracts (see appendix table on the forefront of the privatization program. page 53). Over the past decade the liberalization and privatization programs have dramatically Leasing changed the conditions under which infrastructure services are provided in Malaysia. Leasing is commonly used in privatizing state Private sector provision of infrastructure is infrastructure companies. Under a lease agree- extensive, encompassing ports, roads, power ment a public authority or agency transfers a and telecommunications services, urban infra- state enterpriseÕs physical assets to a private structure, water supply, sewerage, and even Þrm for a speciÞed period, and the private hydroelectric generation (see appendix table on company is required to purchase outright any page 53). The privatization of state infrastruc- moveable assets of the state enterprise, such as ture companies and the opening of many seg- vehicles. The private operator is allowed to ments of the sector to private participation have recoup its lease paymentsÑwhich usually take resulted in an important change in the respec- the form of an initial payment and annual pay- tive roles of the public and private sectors in mentsÑand operating costs through user fees infrastructure development. for the infrastructure services it provides. This shift is clearly evident in the Þnancing Since ownership of the physical assets remains of infrastructure development. Until the Fourth with the government, the private operator Malaysia Plan (1981Ð85) investment in infra- assumes only operational risks. At the expira- structure in Malaysia was entirely Þnanced by tion of the contract the physical assets revert to the public sector. That is no longer the case. The the government. growth in private Þnancing of infrastructure In Malaysia leasing has been used most has been so dramatic since the mid-1980s that often in privatizing ports. The facilities at during 1996Ð2000, coinciding with the Seventh MalaysiaÕs premier terminal, Port Klang, have Malaysia Plan, the private sector is actually set been leased to three port operating companies, to spearhead infrastructure development in the and four other ports are also being run by pri- country. During the Plan period the private sec- vate companies under leases. Under two other tor is expected to invest 68.3 billion ringgit lease agreements the corporatized railway (RM), three and a half times the RM 19.2 billion company is operating the countryÕs rail ser- that the public sector plans to spend on infra- vices and Malaysia Airports Berhad is operat- structure (table 3.1). Including the resources ing its airports. that the private sector is expected to spend on the power industry would further increase the Concessions share of private Þnancing in infrastructure development during the Plan period. By far the largest number of contracts used in the privatization of infrastructure in Malaysia Contracting for private provision of have taken the form of concession agreements. infrastructure Concessions incorporate all the features of a lease contract, but from the outset the private The liberalization of entry into infrastructure company has the additional responsibility of sectors has not meant free entry: private Þrms Þnancing the construction of the project. Thus, Contracting for Private Provision of Infrastructure 45

Table 3.1 Public and private ﬁnancing for infrastructure development in Malaysia, 1991–2000 (ringgit millions) Sixth Malaysia Plan Seventh Malaysia Plan Sector Allocation Expenditure allocation Public sector Transport 12,881.6 11,594.7 15,484.2 Roadsa 8,451.0 7,572.6 9,838.8 Rail 1,802.6 1,735.4 3,370.0 Ports 434.0 410.9 486.8 Airports 1,833.0 1,780.6 1,266.0 Urban transport 361.0 95.2 522.6 Utilities 2,876.3 2,796.7 3,687.3 Water supply 2,749.5 2,671.9 3,575.3 Sewerage 126.8 124.8 l12.0 Communications 76.3 71.0 58.6 Telecommunications and postal services 45.0 39.9 25.5 Meteorological services 31.1 31.1 33.1 Total 15,834.2 14,462.4 19,230.1 Private sector (privatized projects) Investment Roads 17,505.0 Ports 4,241.7 Airports 5,956.0 Telecommunications 25,400.0 Postal services 260.0 Water supply 2,571.7 Sewerage 1,759.4 Rail 10,600.0 Total 68,293.8

Grand Total 87,523.9 a. Excludes local roads in regional development areas, some local authorities, and agricultural roads, which have been allocated RM 700 million. Source: Malaysia n.d. unlike leases, which apply to existing assets, A variation of the concession is the contrac- concessions are used for the development and tual arrangement under which the independent operation of new infrastructure. In a typical power producer projects in Malaysia have been concession agreement the private Þrm underdeveloped. In most countries such projects have takes to Þnance the construction of an infra- involved both a BOT or BOOT concession structure facility and to operate it for an agreed agreement between the government and the period. Consequently, in a concession agree- independent power producer and a power pur- ment the private provider in theory assumes chase agreement between the producer and the both the operational and the investment risks. (often integrated) national energy corporation. The Malaysian government has used con- In Malaysia, however, private power genera- cession contracts for the construction and oper- tion has been brought about through the ation of sixteen major urban and interurban issuance of licenses by the Electricity Supply road schemes, build-operate-transfer (BOT) Department to the independent power pro- projects involving a total investment of more ducer Þrms and a power purchase agreement than RM 17 billion. Three light rail transit pro- between the Þrms and Tenaga Nasional Berhad, jects in the capital city of Kuala Lumpur are the integrated power utility. The reason for this being developed under concession contracts as arrangement was that, from the very beginning, build-operate-own-transfer (BOOT) schemes. the government did not want to bear any of the Concession contracts have also been used for project risks. The power purchase agreements the development of new ports in Malaysia, the are therefore the substantive contractual instru- Lumut Maritime Terminal and the Pelabuhan ment in the development of private power gen- Tanjung Pelepas. eration in Malaysia. 46 Choices for EfÞcient Private Infrastructure Provision in East Asia

Other forms of contracting who initiates the privatization proposal. In Malaysia a privatization project in infrastructure Three other contractual arrangements deserve can be initiated by either the public or the pri- mention. The Þrst is a contract between the gov- vate sector. The procedures for awarding con- ernment and a private provider that essentially tracts in these two cases are similar though not combines a lease and a concession agreement, identical. used in privatizations in which the private company both takes over existing assets and is Projects initiated by the public sector required to develop new facilities. The new terminal at Port Klang, Klang Multi Terminal, is A privatization proposal initiated by the public one example of such an arrangement. Another is sector can be implemented in one of two ways. the privatization agreement between the gov- The government can choose or nominate a pri- ernment and the private operator of Johor Port vate company to undertake the project. Or, if (Seaport Terminal Sdn. Berhad), which consists the government has already undertaken a pri- of a lease for operating the existing facilities and vatization feasibility study, it can direct the a concession agreement to build a new port, Privatization Unit of the Economic Planning Pelabuhan Tanjung Pelepas. Unit to offer the project for direct negotiation Management contracts are another avenue with a selected private company or to call for a for involving the private sector in infrastructure. restricted tender. The choice of approach and of Under a management contract the private con- the private contractor (even in the case of a tractor is responsible only for the operation and restricted tender) is made at the highest politi- management of the government-owned facility. cal level. This type of contract is rarely used in MalaysiaÕs The substantive contracting procedure is the infrastructure sector. The government has same regardless of how the private contractor is signed a few management contracts in the water chosen: sector and a management contract for Penang ¥ The private company (or companies in the Bridge that obligates the private Þrm to invest case of a restricted tender) is required to RM 500 million in improvements and repairs. undertake a detailed feasibility study at its In some infrastructure industries the govern- own expense and to prepare a detailed pro- ment issues licenses to private Þrms to provide posal. services formerly provided exclusively by a gov- ¥ Two committees established by the ernment department or state enterprise. Privatization Unit, the Technical Committee Privatized ports, for instance, operate under a and the Financial Committee, evaluate the license issued by the government, as do Tenaga detailed proposal and undertake negotia- Nasional Berhad and Telekom Malaysia. These tions with the private Þrm. The committees licenses are time-bound and range from twenty- then prepare a joint recommendation and one years for Tenaga Nasional Berhad and submit it to the Economic Planning Unit. Telekom Malaysia to thirty for most of the pri- ¥ The Economic Planning Unit submits the rec- vatized ports. Licenses issued to private compa- ommendation to the Cabinet, which either nies to provide telecommunications services are accepts or rejects it. not time-bound. Although licenses are not in a ¥ If accepted in principle by the Cabinet, the strict sense contracts, like leases and concessions privatization proposal goes through a round they too cannot be had on demand. They also of detailed negotiations between the private impose implicit contractual obligations on the company and the relevant ministry. licensees, and failure to fulÞll those obligations ¥ Upon completion of the negotiations, the pri- can result in their termination. vatization proposal is again submitted for approval by the Cabinet, which even at this Contracting procedures point may reject it. ¥ If the Cabinet accepts the draft agreement (a The procedures used in contracting depend on lease or concession), the ministry and the pri- Contracting for Private Provision of Infrastructure 47

vate company enter into a contract. length of contract period, level of user fees (tolls, port fees, power purchase price), service quality Projects initiated by the private sector standards, and government support (support loans, trafÞc volume supplements for toll roads, A unique aspect of MalaysiaÕs privatization pol- external risk supplements, government assis- icy is that it allowsÑeven encouragesÑthe pri- tance in land acquisition). At the beginning of the vate sector to initiate or propose projects for contracting process the distance between the privatization. In such cases the contracting governmentÕs position and the private ÞrmÕs is process is initiated by the private ÞrmÕs submis- usually quite large. It is during the negotiations sion of an unsolicited proposal to the Economic between the private Þrm and the Technical and Planning Unit. If the initial evaluation Þnds Financial Committees that compromises are merit in the proposal, the unit gives the Þrm a made and agreement is reached. The initial dif- letter of intent and the status of Òpreferred con- ferences on nearly all the vital parts of the concessionaire.Ó This process is tantamount to Þrst tract are now beginning to narrow, largely come, Þrst served because it very nearly accords because both the government (and its agencies) the company that submits a privatization pro- and the private sector have become familiar with posal exclusive right to undertake the project. the range of technical and Þnancial elements. But the company must still prepare and submit a detailed project proposal, including a feasibil- Scope of contract. A typical contract begins ity study, for evaluation by the Technical and with a section containing the provisions of the Financial Committees. The project then goes concession agreement. Other important articles through a process similar to that for a proposal set out the design details for the project, the con- initiated by the public sector. struction schedule, the toll rates or other user fees, the schedule of fee increases, and any gov- Basic features of the contracting process ernment support to be provided. The other articles in a typical concession or lease contract Regardless of how a privatization project is ini- pertain to termination of the contract and dis- tiated, the contracting process will always pute settlement mechanisms. include certain basic features. Evaluation and negotiating mechanism. The Length of negotiations. The larger the project Technical and Financial Committees are the and the more technically complex it is, the principal government bodies for evaluating pri- longer it takes to negotiate the contract. Most vatization proposals and negotiating contracts negotiations for infrastructure privatization in in Malaysia. Their formation has centralized the Malaysia, however, are concluded within six evaluation process, facilitating the entire con- months, and lease contracts take much less time tracting process. The effectiveness of the com- to conclude than do concessions. (Economic mittees depends on the expertise and skills of Planning Unit ofÞcials are of the view that con- their members. The members of the Technical tracting through open, competitive bidding Committee are drawn from the ministries and would take much longer than the sole-source government agencies where the expertise negotiated or restricted tender processes now needed to evaluate a particular proposal is avail- used in Malaysia.) Because of the experience able. Thus for a road project the Technical gained by the evaluating agencies and, equally Committee would include, besides ofÞcials from important, by the private sector bidders, con- the Privatization Unit, ofÞcials from the tracting now is said to take only half as long as Infrastructure Section of the Economic Planning when the privatization program began. Unit and engineers from the Public Works Department, the Highway Planning Unit of the Critical negotiating points. The most important Ministry of Works, the Malaysia Highway negotiating points in contracting for infrastruc- Authority, and the Department of the ture projects relate to technical speciÞcations, Environment. For an independent power pro- 48 Choices for EfÞcient Private Infrastructure Provision in East Asia ducer proposal the committee would include necessary to explain or justify its choice of con- ofÞcials from the Energy Section of the tracting mechanism or of the Þrm to which a Economic Planning Unit and the Electricity contract has been awarded. Supply Department. In addition to representa- There are three possible explanations of why tives from the Privatization Unit, the Financial the government has avoided competitive bid- CommitteeÕs membership includes staff from ding. The Þrst is a belief that awarding contracts the Treasury, the Accountant GeneralÕs OfÞce, through open, competitive bidding involves and the Attorney GeneralÕs OfÞce. higher transaction costs than negotiated con- The two committees are also authorized to tracting. A second possible explanation is a begin the negotiating with the private sector. belief that open, competitive bidding for con- Over time this task has been eased as technical tracts may make it difÞcult to achieve the New benchmarks are established on the basis of ear- Economic Policy objectives. A third possibility is lier projects and as the committees gain experi- that the government has avoided open, compet- ence in assessing the technical and Þnancial itive bidding because it is time-consuming. parameters in the private sector proposal. The Negotiated deals apparently can be completed committees do not have the Þnal word in nego- in half the time required for a competitive bid- tiations. Contracts are Þne-tuned at the Cabinet ding process. level and even during Þnal negotiations with the ministry. Contracting and efÞciency

Open bidding or negotiated contracting? It could be argued that because contracts for infrastructure projects in Malaysia have not The description of the contracting procedures been competitively awarded, some of the poten- above should make it evident that contracting for tial efÞciency gains from privatization have infrastructure privatization projects in Malaysia inevitably been sacriÞced. Although this may does not occur through transparent and compet- well be true, MalaysiaÕs approach to contracting itive bidding. In fact, in the infrastructure priva- includes features that should offset at least some tization over the past decade only one contract of the potential efÞciency losses. has been awarded through competitive bidding (a small independent power producer project in Negotiating process the state of Sabah). In nearly all other infrastructure privatizationÑwhether through divesti- The negotiating mechanism, especially the ture, leases, or concessionsÑcontracting has Technical and Financial Committees and the been through a sole-source negotiated process. In Privatization Unit, appears to function in a way a very few cases, where the project was identiÞed that ensures that private Þrms cannot dictate the by the government, contracts were awarded terms of contracts. Both committees have the through a restricted tender offer. Examples requisite skills and expertise to undertake effec- include the Kuantan Port privatization and the tive and meaningful negotiations with private East Coast Highway, for which three Þrms were Þrms, and it is generally agreed that they give invited to submit tenders. their best effort to obtain the best possible terms In both sole-source negotiated contracting for the government and the public. That the and restricted tender offers, the private com- bureaucracy is a formidable negotiator is con- pany has generally been selected by the coun- Þrmed by many of the private Þrms now tryÕs political leader and the basis of selection involved in the infrastructure sector. therefore cannot be discerned. Despite the fre- There are numerous examples of the bureau- quent criticism that the award of contracts in the cracyÕs effectiveness in negotiations. In many infrastructure sector has lacked transparency cases toll rate proposals have been scaled down and the accusations of political favoritism, the during negotiations and lease and concession Malaysian government has rarely deemed it periods have been shortened. The most recent Contracting for Private Provision of Infrastructure 49 example is the reduction in the sale price of elec- jects were borne by the government. But many tricity from the Bakun Dam concession. of these risks have since been shifted to the pri- One factor that favors the bureaucracy in its vate operators. Similarly, forms of government negotiations with private Þrms is its information support once provided to private operators are advantage. Work by government research no longer as readily available. departments, submissions by other private com- The experience with road projects illustrates panies for the same project, proposals for similar the shift of the burden to the private sector. To projects, and other sources of information pro- enhance the viability of road projects, the gov- duce a huge database that the government can ernment in the past gave private operators assis- use to assess and evaluate privatization propos- tance in the form of support loans, trafÞc volume als. There have been so many road privatization guarantees, and external risk guarantees and projects, for example, that government depart- bore the full cost of land acquisition. But since ments and agencies are sufÞciently well informed 1995 the government has begun to transfer more to undertake effective negotiations on all sub- of the risks in road projects to the private sector, stantive issues of a road privatization proposal. including the cost of land acquisition. (However, In addition to the bureaucratic scrutiny, there the government still gives advances or interest- are at least two other levels of review at which free loans to concession companies to alleviate contracts can be modiÞed to take into account the burden of Þnancing in the early years of the efÞciency considerations and consumer inter- concession.) The transfer of the cost of land ests. The negotiations are subject to scrutiny at acquisition to the concession companies means the highest political level of the Cabinet, and that they must now be more precise in their contracts undergo Þnal negotiation at the min- design work, resulting in less waste in land istry level. Both processes help ensure that pro- intake and thus greater efÞciency. jects are efÞcient. In the electricity sector too there are signs that efÞciency is now a greater consideration. SpeciÞcation of evaluation criteria The Þrst independent power producer project was developed under a take-or-pay power pur- For all infrastructure sectors open to private sec- chase agreement providing little incentive for tor participation in Malaysia, basic technical and efÞciency. For the next four such projects the Þnancial standards and design parameters have agreement did not include take-or-pay provi- been speciÞed. And regardless of which sions, so that the most efÞcient power producer approach has been used to award a contract, would be the Þrst allowed to supply the grid. these standards must be met by the private sup- Changes have also been made in the pricing plier. For roads, for example, privatization pro- mechanism to force power producers to posals must contain a set of technical parameters increase efÞciency. The independent power pro- that meet the standards for design, construction ducer pass-through in the pricing formula was technology, pavement design, and the like that discontinued, and the automatic rate revision are set by the Public Works Department and the clauses have been removed from the licenses Highway Authority. For the Þnancial evaluation, granted to privatized utility companies. proposals must provide project cost estimates, trafÞc and revenue projections, a Þnancial analy- The role of consumers sis, and a Þnancial plan. These technical and Þnancial criteria provide some assurance that the Whatever the mechanism by which the contract projects approved are efÞcient. was awarded, privatization projects have increasingly had to stand up to scrutiny by Allocation of risks Malaysian consumers. On many occasions the public has expressed dissatisfaction over the lev- In the early years of infrastructure privatization els of toll rates, telephone rates, electricity rates, in Malaysia some of the commercial risks of pro- and fees for sewerage services, forcing the gov- 50 Choices for EfÞcient Private Infrastructure Provision in East Asia ernment to renegotiate with the concessionaires. Incorporated concept. The public sector is now encouraged to view the private sector as a part- Factors in the success of contracting in ner in development and to work to ensure the Malaysia success of privatization projects. One outcome of this approach relates to the provision of infor- Even if contracting in Malaysia cannot be said to mation to private Þrms to assist their project guarantee efÞcient infrastructure provision, preparation. Feasibility studies undertaken by there is no doubt that, unlike many other coun- the government or its agencies are now readily tries, Malaysia has succeeded in attracting sig- made available to the private Þrms selected to niÞcant private resources to its infrastructure bid for a project, and departments are encour- sector. In addition to the projects already com- aged to support the ÞrmsÕ project preparation. pleted and under way, many proposals are The public sectorÕs commitment to making under consideration for the privatization of privatization projects succeed is reßected in the existing ports, the development of new port ter- governmentÕs ßexible approach to implement- minals, the privatization of roads, and the devel- ing contracts, best illustrated by projects that opment of independent power producer need to be renegotiated. Contracts have often projects. been modiÞed by mutual agreement because of What explains the governmentÕs success in unanticipated eventsÑsometimes to protect contracting with private Þrms for the supply of government or consumer interests and some- infrastructure services? There are three main fac- times at the request of the private Þrm. There tors. First, the government has a substantial and have been at least four major renegotiations in credible commitment to the privatization of recent years, and the expeditious settlement of infrastructure. Second, the government has con- the issues reßects both the governmentÕs com- sistently shown a genuine interest in making mitment to projectsÕ success and the private sec- privatization projects succeed even if that means torÕs belief that the government is renegotiating renegotiating with the private operators. And in good faith. The following examples illustrate third, the straightforward institutional structure the ßexible manner in which privatization con- for infrastructure privatization and the harness- tracts are implemented in the country: ing of expertise and skills at the Economic ¥ Public protests over the imposition of tolls by Planning Unit to evaluate and negotiate project the private developer of an urban road pro- proposals have facilitated contracting. ject in Kuala Lumpur led the government to There is strong commitment to the privatiza- renegotiate the contract so as to reduce the tion policy among the countryÕs political leader- tolls and delay their imposition. ship. Prime Minister MahathirÕs personal ¥ In the Kelang Container Terminal privatiza- interest in the privatization program lends con- tion agreement the lease contract gave the siderable credibility to the policy. The political company exclusive rights to provide con- stability and the overwhelming strength of the tainer handling services at Port Klang. Soon ruling coalition party also help assure the pri- after the agreement was signed the govern- vate sector that the privatization policy and the ment realized that granting these exclusive economic liberalization program will be sus- rights had been a grave error. When the tained. The Guidelines on Privatisation, remaining facilities at Port Klang were leased Privatisation Masterplan, and Second Outline to a new port operating company that was Perspective Plan all conÞrm the governmentÕs also allowed to develop its own container commitment to privatization. The high-level berths, the government persuaded Kelang commitment creates an environment conducive Container Terminal to drop its exclusive to contracting by limiting the governmentÕs abil- rights. In return the government allowed the ity to behave opportunistically. company to expand its terminal from three The bureaucracyÕs attitude toward the pri- container berths to four. vate sector has become increasingly positive ¥ At the beginning of 1996 PLUS, the conces- since the governmentÕs adoption of the Malaysia sion company for the North-South Contracting for Private Provision of Infrastructure 51

Expressway, was entitled under the conces- Nations Commission on International Trade sion contract to raise its toll rates. But the Law (UNCITRAL). There is no provision for government persuaded the company to legal resolution of disputes. delay the toll hikes and reduce the increase Also contributing to the rapid pace of infra- and began negotiating with PLUS the com- structure privatization in Malaysia is the rate of pensation for this change to the contract. return that the government allows private Þrms ¥ As a result of much public dissatisfaction to earn from investments in the sector. with the way the national sewerage project Independent power producers typically earn was being implemented under a concession returns of about 18Ð19 percent, and concession contract with Indah Water Konsortium, the contracts for road projects are generally tailored government commenced renegotiation of the to give investors a return of 14Ð15 percent. contract. ¥ In 1994 the minister responsible for telecom- Notes munications issued a number of new licenses. In early 1996, however, the new Yahya Yaacob is the Secretary General of the Ministry minister of Energy, Telecommunications, and of Works of Malaysia, and G. Naidu is an associate pro- fessor at the University of Malaya. Post thought that too many licenses had been issued and encouraged consolidation of the industry through mergers among the Þrms. References The matter is now being left entirely to the private sector. Aida, Boey Abdullah. 1996. ÒMalaysia: Towards Vision These examples suggest that contract rene- 2020ÑThe Privatization and Road Development Strategy.Ó Economic Planning Unit, Prime gotiations have been common in Malaysia. But MinisterÕs Department, Kuala Lumpur. they have been neither time-consuming nor Hitam, Samsudin bin. 1995. ÒTransport Infrastructure costly. The governmentÕs ßexibility has con- for Economic Development: The Case for tributed to this. In addition, private infrastruc- Malaysia.Ó Paper presented at the Asian Conference ture Þrms have been extremely cooperative, in on Emerging Role of the State in the Transport Sector in the Perspective of Economic part because they depend on the goodwill of the Liberalization, New Delhi. government for future projects. Renegotiation is Ibrahim, Abdul Khalid bin. 1987. ÔÕPrivatisation and also eased by the operational auditor system, in the New Economic Policy.Ó Paper presented at the which one auditor comes from the government National Conference on Privatisation: Towards the and the other from the private company. This Formulation of a Masterplan, ISIS, Malaysia. system minimizes disputes over requests for Jomo, K.S., Christopher Adam, and William Cavendish. 1995. ÒPolicy.Ó In K.S. Jomo, ed., renegotiation. Privatising Malaysia: Rents, Rhetoric, Realities. Also important in MalaysiaÕs success in con- Boulder, Colo.: Westview. tracting out the provision of infrastructure to Kennedy, Laurel. 1995. ÒTelecommunications.Ó In K.S. private Þrms is the simple institutional structure Jomo, ed., Privatising Malaysia: Rents, Rhetoric, created to deal with infrastructure privatization. Realities. Boulder, Colo.: Westview. Lee, Cassey. 1995. ÒRegulatory Reform in the The Privatization Unit and the Technical and Infrastructure Sector: The Malaysian Experience.Ó Financial Committees constitute an effective Paper presented at the Regional Workshop on and inexpensive contracting mechanism, and Managing Regulatory Policies and Reforms in East the procedures for gaining approval for privati- Asia, Kuala Lumpur, July. zation projects are fairly straightforward. The Malaysia. 1991a. Privatization Masterplan. Kuala Privatization Unit acts as a one-stop agency, Lumpur: National Printing Department. ÑÑÑ. 1991b. The Second Outline Perspective Plan, although approval is also needed from the 1991Ð2000. Kuala Lumpur: National Printing Cabinet and the relevant ministries. But the Department. triple-layered approval system does not appear ÑÑÑ. n.d. Seventh Malaysia Plan (1996-2000). Kuala to be overly cumbersome or complex. Contract Lumpur: National Printing Department. disputes are to be settled by arbitration in accor- Malaysia, Economic Planning Unit. 1985. Guidelines on Privatisation. Prime MinisterÕs Department, Kuala dance with the arbitration rules of the United 52 Choices for EfÞcient Private Infrastructure Provision in East Asia

Lumpur. Mokhtar Tamin, eds., The Malaysian Economy in ÑÑÑ. 1988. ÒNational Ports Plan.Ó Vol. 1, Transition. Tokyo: Institute of Developing ÒOverview.Ó Prepared by PRC Engineering, Inc. in Economies. association with Sepakat Setia Perunding Sdn. Salleh, Ismail Muhd, and Saha Dhevan Meyanathan. Berhad and Aseambankers Malaysia Berhad. Kuala 1993. Malaysia: Growth, Equity, and Structural Lumpur Transformation. Lessons of East Asia Series. Malaysian Economic Association. 1991. ÒBintulu Port Washington, D.C.: World Bank. Privatization Study.Ó Vol. 1. Salleh, Ismail Muhd, and H. Osman-Rani. 1991. ÒThe Naidu, G. 1992. ÒPrivate Provision of Physical Growth of the Public Sector in Malaysia.Ó ISIS, Infrastructure: The Malaysian Experience.Ó Kuala Lumpur. Economic Development Institute Working Paper. Shawal, Abdul Hamid. 1996. ÒMalaysia Privatization World Bank, Washington, D.C. ExperienceÑPast Success, Future Challenges, and ÑÑÑ. 1995. ÒInfrastructure.Ó In K.S. Jomo, ed., an Update on the Malaysian Privatization Master Privatising Malaysia: Rents, Rhetoric, Realities. Plan.Ó Paper presented at the National Privatization Boulder, Colo.: Westview. Summit: PrivatizationÑThe Next Steps. Naidu, G., and Cassey Lee. 1997. ÒMalaysia: The Sulaiman, Ali Abul Hassan bin. 1993. ÒFinancing Transition to Privatization.Ó In Ashoka Mody, ed., Infrastructure Projects: Issues and Recent Policy The Untold Story: Infrastructure Strategies in East Asia. Developments.Ó Paper presented at the 1993 Washington, D.C.: Economic Development Institute, Regional Conference on Financing Infrastructure The World Bank. Projects in South-East Asia, Kuala Lumpur. Ng, Chee Yuen, and Toh Kin Woon. 1992. ÑÑÑ. 1994. ÒInfrastructure Development for ÒPrivatization in the Asian-Pacific Region.Ó Asian Economic Growth: The Case of Malaysia.Ó Paper PaciÞc Economic Literature 6(2). presented at the World Infrastructure Forum, Puthucheary, Mavis. 1987. ÒAn Assessment of the Jakarta. Privatization Guidelines with Reference to Objective Setting.ÕÕ Paper presented at the National Conference on Privatization: Towards the Formulation of a Masterplan, ISIS, Malaysia. Salleh, Ismail Muhd. 1991. ÒPrivatization: The Malaysian Experience.Ó In Hisashi Yokoyama and Contracting for Private Provision of Infrastructure 53

Appendix table Infrastructure privatization and contracting in Malaysia Sector and project Method of privatization Type of contract Ports Klang Port Kelang Container Terminal Sale of equity (1986) Lease (21 + 30 years) Kelang Port Management Sale of equity (1992) Lease (30 + 30 years) Klang Multi Terminal Sale of equity and BOT (1994) Lease (30 years) and concession (33 years) Johor Port Sale of equity (1995) Lease (30 + 30 years) Bintulu Port Corporatization (1993) Lease Penang Port Corporatization (1994) Lease Lumut Maritime Terminal BOOT (1993) Concession Pelabuhan Tanjung Pelepas BOOT (1995) Concession Kuantan Port Sale of equitya Lease

Roads North Klang Straits Bypass BOT (1984) Concession (25 years) Jln. Kuching/Kepong Interchange BOT (1985) Concession (16 years) KL Interchange BOT (1987) Concession (30 years) North-South Expressway BOT (1988) Concession (30 years) Second Link to Singapore BOT (1993) Concession (30 years) Penang Bridge Management contract (1993) Management contract (25 years) Butterworth-Kulim Expressway BOT (1994) Concession (32 years) Seremban—Port Dickson Highway BOT (1994) Concession (30 years) Shah Alam Expressway BOT (1994) Concession (29 years) North-South Expressway Central Link BOT (1994) Concession (25 years) KL-Karak Highway BOT (1994) Concession (27 years) New North Klang Straits Bypass BOT (1995) Concession (25 years) Cheras-Kajang Highway BOT (1995) Concession (30 years) Elevated Highway over Sg. Klang and Sg. Ampang BOT (1996) Concession (33 years) Darnansara-Puchong—Putra Jaya Highway BOT (1996) Concession (33 years) New Pantai Highway BOT (1996) Concession (30 years) Sungai Besi Road BOT (1996) Concession (30 years)

Water supply Labuan Water Supply BOT (1987) Concession Ipoh Water Supply BOT (1989) Concession Larut Matang Water Supply BOT (1989) Concession Semenyih Dam Management contract (1987) Management contract Tube well maintenance, Labuan Management contract (1988) Management contract Johor Water Authority Corporatization (1994) Lease Pulau Pinang Water Authority Corporatization (1987) Lease

Power Tenaga Nasional Berhad Sale of equity (1992) License (21 years) Independent power producers YTL—Paka and Pasir Gudang BOT (1995)b Power purchase agreement (21 years) SEV—Lumut BOT (1996–97)b Power purchase agreement (21 years) GSP—Sepang BOT (1994–96)b Power purchase agreement (21 years) PDP—Port Dickson BOT (1995)b Power purchase agreement (21 years) PSP—Powertek, Malacca BOT (1995)b Power purchase agreement (21 years)

Telecommunications Telekom Malaysia Berhad (1990) License (21 years) Ten private telecommunications operators License Others KTM Berhad (Malayan Railway) Corporatization (1992) Lease Malaysian Airports Berhad Corporatization (1992) Lease National sewerage system BOT (1992) Concession (28 years) Light Rail Transit System I (phase 1) BOOT (1993) Concession (60 + 60 years) Light Rail Transit System I (phase 2) BOOT (1994) Concession (60 + 60 years) Light Rail Transit System II BOOT (1994) Concession (60 + 60 years)

Note: BOT is build-operate-transfer; BOOT is build-operate-own-transfer. a. Transaction was pending in 1996. b. Date of commissioning. Source: Naidu 1995 (updated by author).

4 Regulating Private Involvement in Infrastructure: The Chilean Experience

Alejandro Jadresic

xpanding infrastructure is a main chal- tive. Such reforms have changed signiÞcantly lenge for the Chilean economy. Rapid eco- the structure and operations of the infrastruc- Enomic growth, which has averaged 7.4 ture sector. percent annually over the past decade, is requiring massive investment in energy, telecommu- From state to markets: a historic overview nications, roads, railroads, ports, airports, water supply, and irrigation. In the next six years the Until the 1970s the state was the main player in economy is expected to grow at about 6.0 per- Chilean infrastructure. Through government cent annually and total investment require- institutions and state-owned companies, it was ments in infrastructure are estimated at more the role of the state to plan, Þnance, build, and than $18 billion (table 4.1). operate most of the countryÕs infrastructure. In order to meet such needs without endan- Then in the late 1970s government reforms gering the budget and diverting resources from began to reverse the roles. Privatization of the pressing social needs, Chile has implemented a power and transportation sectors is now nearly policy that allows the private sector to take the complete, and private investment is ßowing into lead in infrastructure investment. Private com- infrastructure construction. panies should meet almost all new investment requirements in telecommunications and energy Major state involvement and a major share in the remaining sectors. In the next six years private investment in infrastruc- Before the Second World War the state was heav- ture should account for about $13 billion, or more ily involved in building roads, ports, railroads, than 70 percent of required investment. airlines, irrigation works, and waterworks. Private participation in infrastructure After the war state involvement strengthened as implies more than capital investment. Chilean a result of policies that explicitly promoted gov- policymakers also rely on the private sector to ernment intervention in developing basic infra- plan, build, and operate infrastructure, and to structure. State-owned companies were created manage the commercial risks associated with for electricity, oil, telecommunications, ship- infrastructure projects. The Chilean economy ping, and urban transportation. Private compa- beneÞts not only from the Þnancial resources nies in such sectors were transferred to provided by private investors but also from their government ownership. State monopolies managerial and technical skills. became the norm. Major reforms have been introduced in the By the early 1970s it had become govern- Chilean economy in order to involve the private mentÕs responsibility to operate and develop sector in infrastructure and reforms are still tak- new infrastructure, relying on the national bud- ing place, since the government is committed to get or income earned by state-owned compa- creating new opportunities for private initia- nies. The government set the prices charged to

55 56 Choices for EfÞcient Private Infrastructure Provision in East Asia

Table 4.1 Estimated infrastructure investment requirements in Chile, 1995-2000 the service providers. State-owned companies were forced to reduce costs and to Þre excess Sector Investment requirements ($ millions) personnel. Stringent budgetary limits were imposed, constraining not only internal opera- Highways 4,250 Urban roads 2,000 tions but also investment plans. Water supply 950 Once these new economic rules were in place Sanitation 1,480 and state-owned companies had balanced their Community facilities 810 Ports 450 budgets, the decision was made to privatize Railroads 470 those activities that could be run on a commer- Irrigation 370 Subways 520 cial basis. The government realized that only the Airports 100 private sector could provide the funds required Rain water and river management 195 to resume investment in expansion of domestic Power industry 3,000 Gas industry 1,500 infrastructure. In many cases privatization had Telecommunications 2,500 to be preceded by legal reforms in order to trans- Total investment requirements 18,595 fer to the government regulatory and planning Source: Chile, Ministry of Public Works data. activities previously performed by state companies and to establish competitive regulatory customers, at levels that were insufÞcient for frameworks. Administrative actions were taken self-Þnancing but that reduced inßationary to split up large enterprises or transform them pressures on the economy. Capital shortages into private corporations. became common in the infrastructure sector and Starting in the late 1970s and continuing national investment plans could not be com- through the 1980s, many companies were priva- pleted. Financial deÞcits worsened in state com- tized in the infrastructure sectors, including the panies where social objectives had fostered the gas distribution company, the telephone com- hiring of excess personnel. pany, Compaatory and planning activities previ- Customers had no choice but to accept con- ously performed by state comps companies, Þve ditions imposed by the sole state supplier. power generation companies, eleven power dis- Protectionist policies had progressively been tribution companies, and an airline (table 4.2). imposed, severely limiting any opportunity for The story of privatization of the electricity and new investors to enter the market. Barriers to telecommunication sectors is told in case studies entry also existed in such sectors as fuel distrib- later in this chapter. ution, air transportation, and shipping, where Different sale schemes were used in the pri- privately owned companies remained as impor- vatization process. In the Þrst phase, through tant players. 1985, entire companies were sold. This made for a faster sale to a single bidder. However, only a The shift to private provision few investors could qualify as potential bidders, given the amounts of capital required; at this In the late 1970s the government introduced rad- stage institutional and foreign investment was ical reforms in the Chilean economy. The guid- not yet important. As a consequence, property ing principles of such reforms were to reduce the was concentrated in a few hands. It was also intervention of the state in the economy, pro- argued that the prices paid were too low. mote private initiative, open markets to interna- To overcome these problems, the next phase tional trade and foreign investment, stimulate of privatization considered a greater diffusion of domestic competition, and lift restrictions limit- property. Very often some shares were kept ing access of new actors in the infrastructure aside for purchase by employees or for civil ser- market. State-owned companies were required vants with the help of long-term credit schemes. to Þnance their operations and investment plans The state also granted soft loans to individuals out of earnings. Prices were deregulated when to buy a limited number of shares, which was competition was feasible or set at levels that called popular capitalism. During this period would cover costs when state monopolies were controlling shares were auctioned only in the Regulating Private Involvement in Infrastructure 57

Table 4.2 Infrastructure companies privatized in Chile, Table 4.3 Infrastructure companies privatized in Chile in 1976–90 the 1990s Company Yeara Sector Company Yeara Sector Gasco 1977 Gas distribution Edelnor 1994 Power generation and transmission Frontel 1980 Power distribution Fepasa 1994 Railroads Saesa 1980 Power distribution Empremar 1995 Shipping Chilmetro 1986 Power distribution Colbún 1996 Power generation Emec 1986 Power distribution Ferronor 1996 Railroads Emel 1986 Power distribution Tocopilla 1996 Power generation Pilmaiquén 1986 Power generation a. Refers to the year when private capital gained control of the company. Télex - Chile 1986 Telecommunications Source: Based on private communication of Rosella Cominetti (Economic Chilgener 1987 Power generation Commission for Latin America). Chilquinta 1987 Power distribution CTC 1987 Telecommunications Emelat 1987 Power distribution portation sector was begun. Control of all power Pullinque 1987 Power generation Edelmag 1988 Power generation and distribution companies has been transferred to the private Endesa 1988 Power generation sector, with special safeguards to ensure the Entel 1988 Telecommunication entry of new players and greater competition. Elecda 1989 Power distribution Eliqsa 1989 Power distribution The state shipping company was sold during Emelari 1989 Power distribution this period and privatization of the railroad sys- Lan Chile 1989 Air transport Pehuenche 1989 Power generation tem was initiated in order to stimulate investment and modernization (table 4.3). Investment a. Refers to the year when private capital gained control of the company. Source: Sáez 1993. during the 1980s in the state-owned railroad had been very low, leading to infrastructure deterio- ration and a decline in railroad use. After a 1992 few cases where massive investment was law allowed the railway company to create a required to boost company development. partnership with the private sector, a controlling Domestic pension funds played a crucial role share of the rail freight business was privatized, in the privatization of state-owned companies, forming two companies: Fepasa, covering the at a time when few large domestic or foreign southern and central part of the country (1995), investors were willing to invest in what was and Ferronor, covering the north (1996). In the seen as a bold liberal experiment in a develop- passenger business, in both suburban and ing country with high political risks and interurban services, conditions are being created unproven regulatory norms. The private pen- to promote private sector participation. A sys- sion fund system had been created in the early tem is being deÞned that will allow private com- 1980s as a replacement for the almost bankrupt panies to bid for a concession granting them the social security system. The new system intro- right to run passenger services on a commercial duced individual accounts managed by private basis. In some cases, where the social rate of companies in a competitive environment regu- return is satisfactory but the commercial return lated by the state. Workers were required to is not, a one-time lump-sum subsidy may be deposit a set share of their earnings in these considered. accounts, with beneÞts based on the accumu- A concessions law has been approved in order lated value of the accounts at the time of retire- to promote private investment in roads, tunnels, ment. Using these forced savings, the new and other transportation infrastructure. pension funds acquired large shares in priva- Concession arrangements allow major projects to tized companies, particularly in the power and be developed and Þnanced by private consortia telecommunications sectors. To this day they that recover their investments by charging user remain a major supplier of funds for the ambi- fees. This system is described in the road and tious investment programs that these companies transportation case study later in this chapter. are undertaking in Chile and in neighboring The next round of privatization will affect countries. ports, water supply, and sanitation. For these During the 1990s privatization of the power sectors the government has proposed legal sector was completed and that of the trans- reforms allowing all new investment to come 58 Choices for EfÞcient Private Infrastructure Provision in East Asia from the private sector. In the case of ports, state- The positive business climate and existence owned regional companies will privatize opera- of clear rules have been important not only for tions. In the case of water supply, privatization privatizing state-owned companies but to of 65 percent of the shares of state-owned com- maintain the ßow of investment. In fact, priva- panies is being considered. Progress to date in tized Chilean infrastructure companies have delineating public and private roles in the water become major investors in other sectors in supply and sanitation sector is described in a Chile and in neighboring countries. After pri- case study later in this chapter. vatization the asset value of ChileÕs infrastructure companies has grown at a rapid pace, Guiding principles much faster than the overall rate of economic growth (table 4.4). Private participation in Chilean infrastructure Favorable business conditions have also sectors is guided by four basic principles, been important to attract investors from Chile embodied in existing laws and in government and abroad for the concession system that is policies and initiatives: promote private invest- being applied to develop road infrastructure. ment, strengthen competition, protect the envi- Low political risks and high credit ratings in ronment, and satisfy basic social needs. The international Þnancial markets have facilitated balancing of these objectives requires a sound private participation in long-term projects (see regulatory system. case study on roads and transportation).

Promoting private investment Strengthening competition

Shortage of infrastructure can become a bottle- Promoting fair competition is a general policy neck for development, requiring allocation of principle for all infrastructure sectors in Chile, massive resources to new projects. But funds are since it is the best way of ensuring efÞcient oper- required to meet pressing investment needs in ation and better services to consumers. Chile was social areas such as education, health, and hous- a pioneer in deregulating its power and telecom- ing, where it is difÞcult to attract private capital. munications industries within a competitive In fact, at present 70 percent of the stateÕs budget framework. There are no restrictions on investors is allocated to social areas. There is no choice but wishing to enter the market nor on customers, to rely on private capital for infrastructure expan- who may choose among different suppliers. As a sion. In addition, private participation works as a result, capacity shortage has been completely mechanism to promote efÞciency in constructing eliminated, the most modern technology is being and operating infrastructure: the proÞt motive used, prices have gone down, and companies are makes cost reduction a high priority. still earning fair returns (see case studies on elec- Chile has been very successful in promoting tricity and telecommunications). private investment in infrastructure. A key It is important to stress that no state guaran- incentive has been the persistence of a favorable tees or privileges are involved in telecommuni- investment climate in the economy as a whole. cations or power projects. Companies develop A stable political system, a well-developed projects at their own risk, estimating demand, Þnancial sector, openness to trade and foreign setting prices, and negotiating with Þnancial investment, and capable government institu- institutions. Price regulation applies only to tions have contributed to this climate. In addi- small customers for services in markets where tion, regulatory norms established for the main there are natural monopolies, such as telephone sectors have applied clear and stable rules. The services and electricity distribution. duties and rights of private operators are A similar policy has recently been adopted to deÞned in sectoral laws, which clearly distin- develop the natural gas industry, supplied by guish the regulatory role of the state and the pipelines from Argentina. An open and compet- managerial role of both private and state-owned itive framework is allowing rapid development companies. of this industry, with no involvement by the Regulating Private Involvement in Infrastructure 59

Table 4.4 Asset value of selected privatized companies in Chile Compañía de Teléfonos de Chile Entel Chilgener Assets Increase Assets Increase Assets Increase Year ($ millions) (percent) ($ millions) (percent) (pesos millions) (percent) 1987 507 – 139 – n.a. n.a. 1988 754 48.7 154 10.8 n.a. n.a. 1989 975 29.3 209 35.7 n.a. n.a. 1990 1,379 41.4 259 23.9 n.a. n.a. 1991 1,688 22.4 301 16.2 408,515 n.a. 1992 2,124 25.8 362 20.3 460,326 12.7 1993 2,481 16.8 394 8.8 605,245 31.5 1994 3,065 23.5 533 35.3 643,063 6.2 1995 3,658 19.3 644 20.8 669,895 4.2 1996a – – – – 781,484 16.7

– Not available. n.a. Not applicable. a. As of September 30, 1996. Source: CTC, Melo and Serra 1996; Chilgener Estrategia, November 25 and December 16, 1996 national governments in project selection or Protecting the environment Þnancing. Equal access is guaranteed to all customers requiring gas transportation services Environmental protection has become a major provided by pipeline owners, and there are no political priority in recent years. New norms and constraints on investors wanting to build and legislation have been approved to provide clear operate new gas pipelines. rules to investors and ensure that all infrastruc- New legislation is being introduced to create ture projects are developed in a sustainable a fair and competitive environment in the port manner. Preventing environmental damage is and water supply and sanitation sectors that will the reigning principle. allow private companies to provide most of the A clearly deÞned review process, with Þxed investment required with adequate safeguards deadlines for Þnal authorization, has recently for consumers. In the case of ports, the large been established, including detailed regula- state-owned company Emporchi will be divided tions. It requires environmental impact assess- into ten separate, autonomous companies, ment studies for most large projects, indicating which will be allowed to compete among them- any mitigation measures required. Many large selves and to attract private capital for infra- projects undertaken in recent years have per- structure expansion. In the case of water and formed such studies on a voluntary basis even sanitation, new legislation will allow privatiza- when not required to do so by law. tion of state-owned enterprises, within a regula- Environmental studies are reviewed by an ad tory framework that promotes efÞcient hoc technical committee composed of represen- operation and marginal cost pricing (see case tatives from public institutions involved. The study on water supply). National Commission for the Environment In the case of roads and other transportation (Conama) or its regional ofÞces, depending on infrastructure, the state has kept a key planning the projectÕs coverage, makes the Þnal decision role but grants concessions to private parties about the projectÕs environmental feasibility. allowing them to build and operate infrastruc- Third parties that are affected by the projects ture and charge user fees. This newly introduced may Þle comments during the review process. concession system ensures a competitive, trans- Some infrastructure projects need to meet parent, and open bidding process that allows the speciÞc environmental and safety standards, best projects to be chosen. The only state guar- such as emissions standards for air and liquid antee is one safeguarding minimum earnings pollutants, quality norms for construction mate- from user charges (see case study on roads and rials, and route design constraints for roads and transportation). pipes. Such standards are usually based on international experience. 60 Choices for EfÞcient Private Infrastructure Provision in East Asia

Satisfying basic social needs telecommunications and transportation markets, including urban and intercity trafÞc, rail- It is a government objective to provide basic roads, airlines, and shipping. The National social infrastructure to all Chileans. Yet existing Energy Commission oversees oil, coal, gas, and policy recognizes that it may be unproÞtable for electricity markets. private investors to serve isolated areas or low- Technical and economic regulation is carried income groups. To overcome these limitations out by specialized institutions. There are super- the government provides funds for projects that intendencias for water supply and for electricity meet minimum social and economic targets. and fuels, subsecretar’as for transport markets Most infrastructure projects that the govern- and telecommunications, and direcciones gen- ment will Þnance in the next few years would erales for irrigation, roads, and air transporta- very likely not be developed by the private section. In addition, there is a Þscal’a (prosecutorsÕ tor because of low proÞtability or because it is ofÞce) and antitrust commissions that monitor difÞcult to charge users. competition throughout the economy, including Mechanisms have been introduced to maxi- the infrastructure markets. The National mize provision of basic social infrastructure by Environmental Commission is responsible for private investors. Direct subsidies are the pre- environmental policy and regulation. ferred measure. For instance, government funds The performance of government institutions are supplied in a competitive way to private helps to explain the positive role that the private electric and telecommunications utilities that sector has played in Chilean infrastructure. serve rural areas and to ships that serve isolated However, further modernization may be needed islands. In the case of water supply and sanita- to ensure that regulatory duties are performed tion, the state provides a direct subsidy to poorer more efÞciently in the future. For that reason the families, so they can pay the regulated tariffs government is promoting administrative and charged by the companies, which are set at cost. legal reforms in order to strengthen technical About 20 percent of Chilean families receive this capabilities and enhance the power and auton- beneÞt. Mechanisms like these allow poor fami- omy of regulatory agencies. Recruitment of lies to satisfy their basic needs without obliging highly qualiÞed staff at the regulatory agencies the state to build or operate infrastructure but is a main concern. Attractive job opportunities only to provide efÞcient market incentives to and good salaries in the private sector make it private investors. difÞcult to attract top professionals needed in the public sector. A number of incentives are Capable state regulation being considered, including improved salary schemes for regulators and use of external con- Private participation does not imply state with- sultants for highly specialized tasks. Another drawal from the infrastructure sector. On the concern has been to give regulatory agencies contrary, it requires active and effective involve- greater legal authority to ensure enforcement of ment of state entities to ensure that private regulatory norms. Likewise, arbitration mecha- actors operate in line with social goals. To do nisms are being considered for resolution of dis- this, state entities must rely on highly qualiÞed putes between agencies and companies that personnel who understand and can implement would minimize the need for court litigation. the regulatory framework. Several state entities are involved in Chilean infrastructure. Private participation in four infrastructure Ministries dictate government policy and are sectors responsible for the overall performance of spe- ciÞc sectors. The Ministry of Public Works over- Case studies of the electricity, telecommunica- sees transportation infrastructure (roads, ports, tions, water supply and sanitation, and roads airports), water supply, sanitation, and irriga- and transportation sectors describe the process tion. The Ministry of Transport and Telecom- of privatization and the different mechanisms munications is responsible for the operation of used. Regulating Private Involvement in Infrastructure 61

The electricity sector: wholesale divestiture every four years for distribution charges; mandatory interconnection and rights of way In its early stages the development of the for electricity transmission over third-party sys- Chilean electricity sector was driven almost tems; and a coordination mechanism for load exclusively by private initiative, but this sce- dispatching. nario changed after the Second World War. In The next step was to prepare the companies 1943 the state-owned company Endesa for privatization. Chilectra was divided into (National Electric Company) was created by the two distribution companies (Chilectra and industrial promotion agency (Corfo) in order to Chilquinta) and one generating company carry out the national electriÞcation plan. (Chilgener). Regional distribution activities Endesa undertook several tasks. It planned the and a few smaller generation plants were sepa- extension of electricity to cover the whole coun- rated from Endesa to become individual incor- try, studied the availability of hydroelectric porated companies. The largest generation resources, trained the people required for the facilities and the transmission lines remained sectorÕs development, built hydro- and thermo- the property of Endesa. electric generating units in different regions of Although care was taken to divide existing Chile, extended trunk lines and started inter- companies, the electricity sector remained quite connecting them, and expanded urban and rural concentrated. Much of the regulatory effort in distribution systems. Endesa was a privileged recent years has been directed to facilitating the state company and could count on having entry and operation of new actors in this market. highly qualiÞed personnel and plentiful This might not have been necessary had Chile, resources. like some countries that have undertaken priva- Some private companies coexisted with tization recently, been more careful to create a Endesa but they progressively lost ground. The competitive set of companies before divesting to most important was Chilectra, which produced private investors. and distributed electricity in Santiago and In the second half of the 1980s the main Valpara’so and their suburbs. In 1970 Chilectra power companies were privatized, including was nationalized, so by the mid-1970s the state Endesa. Open sales of small share packages on controlled 90 percent of generation capacity, 100 the stock exchange were the basic mechanism. percent of high-tension transmission lines, and The major buyers were the private pension 80 percent of distribution systems. funds, although shares were offered also to The Þrst step in reforming the electricity sec- employees and civil servants. Shares in electric tor was taken in 1978 with the creation of the companies still constitute about half of pension National Energy Commission (CNE). The com- fund investment in private stocks. mission would operate independent of state- The privatization process generated a posi- owned companies and would promulgate tive interaction between the power and Þnancial policies, development plans, and regulations for markets. Shares and other Þnancial instruments the electricity and other energy sectors. The CNE offered by the electric companies became very would lead the reform process in these sectors. attractive in the Þnancial market. The real value A new electricity law was approved in 1982, of electric companiesÕ shares increased almost establishing an innovative decentralized model one thousand times between 1984 and 1994 and for developing the electricity sector, which so far rose from about 2 percent of the total value of had operated as a vertically integrated, state- shares traded in the early 1980s to more than 45 owned monopoly. The new approach involved percent in the early 1990s (table 4.5). the separation of generation, transmission, and The electric companies also initiated vigor- distribution activities; free entry and competi- ous investment and expansion efforts both in tion in electricity generation; a concession sys- Chile and abroad. Over the past ten years elec- tem for distribution; a marginal cost pricing tricity consumption has grown about 8 percent scheme for small customers, which is reviewed annually, while total annual investment is every six months for generation charges and approaching $800 million. Prices have started to 62 Choices for EfÞcient Private Infrastructure Provision in East Asia

Table 4.5 Chilean electric company shares traded, 1980–94 Table 4.6 Chilectra’s electricity losses, 1983–92 (as percentage of production) Value of Total value of Electric electricity company shares traded company shares Year Losses shares traded (1993 pesos as percentage 1983 22.4 Year (1993 pesos millions) millions) of total 1984 19.3 1980 3,801 201,669 0.02 1985 20.4 1981 1,255 125,816 0.01 1986 20.9 1982 1,148 59,062 0.02 1987 19.8 1983 1,366 29,6227 0.05 1988 18.8 1984 788 23,926 0.03 1989 16.1 1985 5,740 34,107 0.17 1990 13.6 1986 63,242 192,409 0.33 1991 13.3 1987 92,540 309,841 0.30 1992 12.0 1988 93,643 373,108 0.25 Source: Chilectra n.d. 1989 146,617 468,091 0.31 1990 186,764 394,293 0.47 1991 403,271 904,104 0.45 1992 334,595 884,273 0.38 tive manner to companies willing to extend the 1993 547,397 1,191,148 0.46 electricity network in rural areas. 1994 765,019 2,088,827 0.37 A related development that is having a posi- Source: Paredes 1995. tive effect on the electricity industry is the construction of pipelines across the Andes to bring fall as competition in power generation has natural gas from Argentina for combined cycle become stronger and productivity in distribu- thermoelectric plants and industrial and resi- tion companies has increased (table 6). At the dential uses. The idea of building a gas pipeline same time the electric companies have become is very old but has long met resistance for polit- major investors in neighboring countries that ical, economic, and technical reasons. In 1990 the have started to deregulate their own electric Chilean and Argentine governments called for companies, making use of experience gained international bids by private consortia inter- operating in deregulated markets. Chilean com- ested in building such a project but had to can- panies now control between a fourth and a third cel when they realized that they had no objective of installed capacity and distribution in both way of selecting a winner. The two governments Argentina and Peru and are starting to invest in later decided to open the market fully and let Bolivia, Brazil, and Colombia. private investors take the initiative. This liberal The modernization process has received fur- trade agreement granted no exclusivity rights or ther impetus during the 1990s. The last remain- state guarantees, allowed buyers and sellers to ing state-owned power companies have been set the terms of the gas supply contracts, and sold with safeguards ensuring that they would required open access conditions for gas trans- not be acquired by either of ChileÕs main private portation. These conditions set the stage for suc- generation companies and that they would cess. Fierce competition developed between two undertake investment plans to consolidate their consortia until one of them was able to sign competitive position in the market. New norms enough supply contracts with buyers and this are also being introduced to improve the regula- consortium will start transporting gas in 1997. tory framework, strengthen competition, and The second consortiumÕs project was sus- ensure that new projects protect the environ- pended, but new private projects to build ment. These norms cover the quality of service pipelines across the Andes and distribute gas in to be provided by regulated utilities, the fees to Chile are being developed. be paid by power generating companies using third-party transmission facilities, and environ- Telecommunications: gradual privatization mental impact assessment studies required before building new projects. Mechanisms have Telephone service was introduced in Chile as been designed to promote investment by private early as 1880, only four years after its invention. distribution companies in rural electriÞcation In 1927 the main company was acquired by the projects: state funds are provided in a competi- International Telephone and Telegraph Regulating Private Involvement in Infrastructure 63

Corporation (ITT), an American corporation, interim (box 4.1). and was incorporated in 1930 as Compa–’a de Privatization of CTC started in 1987, when TelŽfonos de Chile (CTC). CTC soon acquired minority shares were sold to company employ- other, smaller companies and became a virtual ees and to pension funds and a request for bids monopoly, serving more than 90 percent of the was issued for a 30 percent controlling share market. with a requirement for continuing investment. In 1964 the government created a state- An Australian conglomerate, the Bond owned company, Entel, to provide national and Corporation, won the bid and then sold its share international long-distance services and to rep- in 1990 to a Spanish company, Telefnd to pension resent the country in international agencies such funds and a request for bids was issued for a 30 as Intelsat. In 1971 the government took over the percent controlling share with a requirement for management of CTC and in 1974 bought it from continuing investment. An Australian conglom- ITT. ChileÕs telecommunications sector was then erate, tame important minority shareholders. dominated by a state-owned duopoly, with local The privatization of Entel was conducted services provided by CTC and long-distance ser- slightly differently. Between 1986 and 1990 all vices by Entel. Telephone rates were based on shares were sold either on the stock exchange or long-term average costs and a 10 percent proÞt to company employees. The pension funds were rate was allowed. In practice, however, rates the main buyers. Telef—nica de Espa–a acquired were kept low for political reasons and rate 20 percent of the company, but after it took con- increases frequently failed to keep pace with trol of CTC the Antitrust Commission forced it inßation. There were cross-subsidies in favor of to divest its share in Entel. Divestiture was com- local service. Investment was modest and unsat- pleted in 1993. Today Entel is controlled by a isÞed demand grew. partnership formed by the Chilean company Reform started in 1977 with the creation of Chilquinta and the Italian company STET/ the Subsecretar’a de Telecomunicaciones Telecom, each holding 19.5 percent of shares, (Subtel), an independent body. Its role was to with the pension funds and other groups as design policies and technical norms and per- minority investors. As a private company, Entel form regulatory duties, including the granting ceased to represent Chile in international of concessions and calculation of tariffs for reg- telecommunications agencies. ulated services. The principles of the new regulatory frame- Box 4.1 Calculating regulated local telephone rates work were established in the General Law of To calculate regulated local telephone rates, service regions Telecommunications, approved in 1982 and are grouped into a few areas according to demographic modiÞed in 1987. The law granted equal rights parameters. An ideal, state-of-the-art, efficient company to private and state-owned companies, within a serving each of these areas is defined, usually on the basis of concession system that allows a company (the proposals from the companies, which are checked by the concessionaire) to operate providing that it fol- regulator. In this simulation of a competitive environment lows a set of well-deÞned regulations. Prices prices are calculated on the basis of marginal costs derived were freed from regulation except for services from investment and operation costs’ required for service expansion in line with five-year demand forecasts. The price that the Antitrust Commission allowed to be structure includes fixed and variable charges, with the vari- provided under monopoly conditions. Free able charge depending on the number and duration of calls. entry to the market was allowed for new com- The charge per unit of time varies according to the call vol- panies. Service and interconnection obligations ume in peak and nonpeak periods of the day. If these charges were imposed on telephone companies. Cross- do not yield the allowed profit rate because of economies subsidies were eliminated and a long-run mar- of scale, they are adjusted upward, but in such a way as to ginal cost pricing scheme was introduced for minimize the resulting reduction in social welfare. telephone services, with a market proÞt rate Rates have been set twice according to this procedure, with the second process resulting in a reduction. Telephone determined by the capital asset pricing model. companies have continued to invest heavily in the expansion Prices were to be recalculated every Þve years, of local service coverage. with an index mechanism to be used for the 64 Choices for EfÞcient Private Infrastructure Provision in East Asia

Further reforms were introduced in the one of SubtelÕs main objectives is to modernize 1990s. The law was modiÞed to fully open the itself in order to improve its regulatory perfor- market for long-distance services and introduce mance. State agencies must match the efÞciency a multicarrier system allowing any customer to and productivity improvements of the private choose among suppliers for each call. Rates have sector. One of the main changes being consid- been freed from regulation and new companies ered is the creation of a superintendencia of have entered the market, making it one of the telecommunications, which would be in charge most competitive in the world. of monitoring company compliance with regu- In addition, a state fund Þnanced by the bud- lations and imposing appropriate sanctions, get has been created to promote expansion of the tasks currently performed by Subtel. Subtel telecommunications network to rural areas. would retain responsibility for the political Rural communities prepare and propose pro- aspects of the telecommunications sector, jects with government help. The projects are including the design of laws and regulations, the usually attractive from a social perspective but granting of concessions, and the calculation of not from a commercial one. The fund provides regulated rates. an investment subsidy to make the projects prof- itable and private companies compete to receive Water supply and sanitation: private investment, it. Proposed projects are evaluated by a central government regulation council according to their social value. This program is giving hundreds of communities nation- Water supply and sanitation services in Chile wide access to telephone services. have traditionally been provided by the state. The deregulation and privatization of For many years this task was in the hands of the telecommunications have had very positive Ministry of Public Works, through its results for the Chilean economy. Investment Directorate for Sanitary Works, and of several has expanded signiÞcantly. The number of tele- municipal and state companies or agencies serv- phone lines has more than tripled in eight ing individual cities. There were also a few small years, and unsatisÞed demand has almost dis- private companies that struggled to survive appeared (table 4.7). New technologies and ser- with low, government-set tariffs. vices have been introduced, and the network Reform was Þrst attempted in 1977 with the has been fully digitized. Companies have creation of the National Sanitary Works Service diversiÞed their services in both regulated and (Sendos), which integrated all state institutions nonregulated businesses, including cellular involved in water supply and sanitation, includ- telephones, cable TV, and private telephone ing the Directorate for Sanitary Works and the services. Seven companies offer long-distance municipal companies. Sendos was an services (formerly monopolized by Entel), autonomous organization within the Ministry of demand has grown sixfold in the past eight Public Works that covered the whole country years, and prices have fallen dramatically. through eleven regional departments. Competition is also developing at the local Sanitation services in the two main cities in the level as new companies have taken on overlap- country were left in the hands of two state- ping concessions and ambitious expansion pro- owned companies: Emos in Santiago and Esval jects. Future plans include technologies such as in Valpara’so. The role of Sendos was to plan, Personal Communication Systems (PCS), build, and operate water supply and sewerage which will compete directly with cellular systems, as well as to set quality standards and phones in the short run and possibly with local monitor compliance; the Ministry of the service in the long run, as prices fall as a result Economy set tariffs. This scheme allowed of economies of scale and better technology. greater coordination among state units but had Subtel, the state regulator, has played an its problems, stemming mainly from SendosÕs important role in deregulating the telecommu- dual role as operator and regulator. nications sector. It has deÞned policies and mon- More far-reaching reform was introduced in itored compliance with existing norms. Today 1989, when the regulatory role of the state was Regulating Private Involvement in Infrastructure 65

Table 4.7 Chilean telephone service after deregulation, 1987–95 Lines in service Telephone density Quantity Annual increase Lines per Annual increase Waiting lista Year (thousands) (percent) 100 inhabitants (percent) (thousands) 1987 581 – 4.65 – 232 1988 631 8.6 4.93 6.0 236 1989 689 9.2 5.40 9.5 284 1990 864 25.4 6.56 21.5 308 1991 1,056 22.2 8.02 22.3 241 1992 1,279 21.1 9.56 19.2 314 1993 1,516 18.5 11.10 16.1 198 1994 1,657 9.3 11.97 7.8 117 1995 1,894 14.3 13.42 12.1 52 – Not available. a. For Compañía de Telecomunicaciones de Chile (CTC), the largest company. Source: Melo and Serra 1996, based on data from Subtel and company annual reports. separated from the operational role of compa- proÞtability (table 4.8). nies, whether state-owned or private. New laws The current administration has decided to provided the framework for efÞcient develop- promote further reforms in this sector. In order ment of water supply and sewerage services to achieve 100 percent coverage for water sup- using a concession system, which imposed sev- ply and sewerage, undertake major invest- eral regulations on concessionaires. They were ment in sewerage treatment plants, and allowed to Þnance operations and investment introduce new technologies and managerial required for expansion with tariffs set every Þve skills, much greater private capital participa- years according to marginal cost criteria. A sys- tion is required. Therefore the decision has tem of direct subsidies for low-income con- been made to privatize Emost, Esval, and the sumers was introduced to offset the impact of regional state-owned companies. A bill was higher tariffs and was essential in allowing tar- sent to Congress to allow the government to iffs to be based on costs. Service obligations and sell up to 65 percent of these companiesÕ shares quality norms were imposed on all companies. to private investors. By retaining a 35 percent Compliance with these laws and regulations share, the state will keep some veto power over was ensured by a system of Þnes and sanctions. major corporate decisions. Each of SendosÕs eleven regional depart- At the same time, the government has pro- ments was transformed into a state-owned posed legal reforms that will strengthen the reg- incorporated company with the same rights ulatory powers and capabilities of the and duties as Emos, Esval, and the few remain- Superintendencia. Private control of natural ing private or municipal companies. monopolies in the water and sanitation sector Regulatory duties were assigned to the will require stronger regulatory authority. Superintendencia de Servicios Sanitarios, a SpeciÞc norms have been considered to improve newly created body, which was given the right the method for calculating tariffs and to restrict to grant concessions to commercial companies horizontal integration of water companies. interested in providing water and sewerage services, calculate tariffs, impose sanctions, Roads and transportation infrastructure: the and regulate and monitor compliance with concession system technical and quality norms. Its head, the superintendente, is appointed by the president The traditional source of Þnancing for construc- and has a great deal of autonomy. tion and maintenance of roads has been the state The new regulatory model has allowed com- funds allocated to the budget of the Ministry of panies to increase investment in sanitation sys- Public Works. Tolls for use of intercity roads and tems based on earnings, expand water supply taxes on transportation fuels have been charged and sewerage coverage, and achieve higher for many years, but the resulting income has not 66 Choices for EfÞcient Private Infrastructure Provision in East Asia

Table 4.8 Performance of the Chilean water and sanitation sector following reform tleneck to economic development. ChileÕs Investment in sanitation, 1965–95 export-led growth model needed an efÞcient transport network, since road transit was grow- Investment Period (1995 $ millions) ing at 9Ð10 percent annually, and new transport capacity would be required to handle new trade 1965–70 71 1971–73 65 following trade agreements to be signed with 1974–9 68 neighboring countries. It was estimated that the 1990–95 151 annual losses due to the road deÞcit amounted Source: Superintendencia de Servicios Sanitarios data. to nearly $1.5 billion, stemming mainly from congestion, pollution, accidents, and load losses Urban residents with water and sewerage services, selected years, 1965–95 due to inadequate transport infrastructure. The government also signiÞcantly increased invest- Urban Water service Sewerage service population coverage coverage ment in roads, but it became clear that the state Year (millions) (percent) (percent) would be unable to meet all investment require- 1965 5.85 53.5 25.4 ments. In order to satisfy the medium-term need 1970 6.67 66.5 31.1 for new roads, 1,200 kilometers of roads would 1975 7.62 77.4 43.5 need to be paved every year, far more than the 1980 8.89 91.4 67.4 1985 9.66 95.2 75.1 500 kilometers paved by the government in a 1990 11.40 97.4 81.8 good year. 1995 11.99 98.6 89.2 The solution was to involve the private sector Source: Superintendencia de Servicios Sanitarios data. in obtaining additional funds and also to intro- Profitability of state-owned water and sewerage duce new managerial practices and technologies. companies, 1988–95 The concessions law approved in 1991 established the framework that would apply for pri- Year Profitabilitya vate companies willing to invest in constructing, 1988 –1.36 1989 –0.76 operating, and maintaining roads and other 1990 –0.82 transportation infrastructure. The concession 1991 –0.13 system involves mainly projects deÞned by the 1992 0.94 1993 3.56 state. Concessions are granted through a bidding 1994 5.19 process, with potential investors submitting 1995 6.30 offers that must satisfy speciÞc conditions stated a. Profits after taxes as percentage of total assets. in the terms of reference. The process is trans- Source: Superintendencia de Servicios Sanitarios data. parent and competitive and does not involve bilateral negotiations. The concession system is ßexible and can be applied to roads, ports, and necessarily been used to extend the transport other transportation infrastructure. The law network. Not surprising, supply has fallen short allows private pension funds and insurance of demand and the road deÞcit has increased. companies to invest in the concession projects. The investment shortfall became more severe in Bids for road concessions are analyzed from the 1970s and the 1980s, since restricting infra- both a technical and an economic perspective. structure investment was a preferred method for Selection is based on such criteria as the Þghting inßation in Chile as in many other Latin requested toll level, the tariff structure, the con- American countries. It has been estimated that cession period, the subsidy requested or pay- during the 1980s only 30 percent of road investments committed to the state, the score on the ment needs were met. Road trafÞc has increased technical evaluation, and environmental consid- almost fourfold in the past twenty-Þve years, erations. The selected bidder must create a cor- while the road network has remained nearly poration devoted exclusively to the project unchanged. deÞned by the bid. In the early 1990s the government realized The concessionaire is required to build or that the road deÞcit could become a major bot- improve, operate, and maintain the roads dur- Regulating Private Involvement in Infrastructure 67

Table 4.9 Road and transportation projects offered for concession in Chile, 1993–99 Amount to be awarded ($ millions) Investment Projects ($ millions) 1993 1994 1995 1996 1997 1998 1999 Route 5a 1,690 0 0 160 710 820 0 0 Urban concessions 870 0 0 10 250 290 100 220 Interurban concessions 1,533 42 30 381 140 440 500 0 Total 4,093 42 30 551 1,100 1,550 600 220 a. Route 5 is the country’s main highway. It is part of the Panamerican Highway System stretching from Alaska to Patagonia. Source: Chile, Ministry of Public Works 1996. ing a concession period lasting no more than into account international experience. Þfty years in exchange for toll income. The gov- The Þrst concessions were awarded in 1993. ernment usually offers a minimum income guar- Two projects have been Þnished so farÑone tun- antee based on trafÞc assumptions. This nel and one roadÑseveral more are being built, guarantee, which is normally accepted by the and others will soon be tendered. The estimated winning companies, has two main goals: to help value of projects to be awarded in 1993Ð99 the private investor obtain Þnancing and to exceeds $4 billion (table 4.9). show the stateÕs commitment to the project. The Although it is too soon to evaluate the long- Þnancial backing is important, since the conces- term operational outcome, the Chilean experi- sion grants only the right to exploit the infra- ence with the concession system has so far been structure for a given period; the state remains very positive. The private sector, both in Chile the owner of the road works from the beginning and abroad, is highly motivated to invest in of the project. The income guaranteed by the roads and other transportation infrastructure state usually covers maintenance costs and that the economy badly needs in order to keep about 70 percent of operating and capital costs. growing. The system allows reduction of the But if proÞtability exceeds a previously estab- road deÞcit while freeing government resources lished level (usually 15 percent), the concession- for other uses, including the construction of aire has to share the additional income equally roads that are socially desirable but do not meet with the state. A conciliation mechanism is minimum commercial conditions to be offered available in case of conßicts arising between the as concessions. investor and the state during the concession Several factors help to explain the positive period. response from private investors to concession Private investors may also propose new pro- projects, even if the expected proÞtability is not jects. If a project is accepted, the company that high. Internationally, the country is assessed as proposed it receives a bonus in its bid and may one with low political risk and institutional and receive a full or partial refund of the develop- macroeconomic stability. The Ministry of Public ment costs associated with the project. Many Works has carefully overseen thorough prepara- projects have been proposed, several have been tion of the required studies and undertaken accepted (including two airport terminals and broad promotional efforts. Investors also cannot urban and interurban roads), and some are have failed to notice the steadily increasing being built. demand for this type of infrastructure, which The Ministry of Public Works has created a can be expected to keep pace with the economyÕs Concessions Division to regulate the concession sustained growth. system. This division deÞnes projects to be offered, manages the bidding process, and Conclusion supervises project construction and operation . Regulations governing the concession system Chile has come a long way in deregulating and and the bidding process have evolved over time. privatizing its infrastructure sectors. The private The government has introduced modiÞcations sector is now involved not only in Þnancing to solve problems as they have arisen, taking investment projects but also in planning, build- 68 Choices for EfÞcient Private Infrastructure Provision in East Asia ing, and operating new infrastructure facilities. and legal reforms that will strengthen its Þnan- Such participation is guided by general princi- cial and technical capabilities as well as the ples, including promoting investment, ensuring power and autonomy of its regulatory agencies. fair competition, protecting the environment, and satisfying basic social needs, and by capable Notes regulation. The current situation owes its success to the The author is Minister President of the National design of major reforms that have been intro- Energy Commission. The author wishes to acknowl- edge Mr. Gaston Held for his valuable help, especially duced over the past twenty years. Generally with the case studies, for the field work performed, speaking, sectoral reforms have started with the and for his useful comments. creation of a regulatory institution to lead the process and of a legal and regulatory framework. The next step has been the privatization of References state-owned companies in the case of electricity and telecommunications and the granting of Acevedo, Roberto, and Juan Err‡zuriz. 1994. concessions to let the private sector undertake ÒInfraestructura: oportunidad u obst‡culo para el desarrollo.Ó (Infrastructure: opportunity or obstacle new projects in the case of roads. This sequenc- for development.) In Felipe Larra’n, ed., Chile hacia ing strategy has proved to be effective. Private el 2000: Ideas para el desarrollo. (Chile in the year investment requires clear and stable rules estab- 2000: Ideas for development.) Santiago de Chile: lished by law and a regulatory body indepen- Centro de Estudios Pœblicos. dent from potential state-owned competitors. AlŽ, Jorge, and others. 1990. ÒEstado empresario y pri- vatizaci—n en Chile.Ó (Entrepreneurial state and pri- Accelerating the process by starting privatiza- vatization in Chile.) Cuadernos Universitarios, Serie tion without a proper regulatory framework Investigationes 2. Universidad Nacional AndrŽs does not seem to pay off, since high risk will Bello, Facultad de Ciencias Econ—micas y drive away potential investors and it is difÞcult Administrativas, Santiago de Chile. to modify regulations once property rights have Chile, Ministry of Public Works. 1996. ÒPrograma gen- been awarded. eral de concesiones.Ó (General concession program.) Coordinaci—n General de Concesiones, Santiago de Private participation in infrastructure has Chile. had strongly positive effects on the Chilean Chilectra. No date: ÒChilectra highlights.Ó Chilectra economy. Massive private investment has been Metropolitana (Company publication). taking place in energy and telecommunications D’az, G.-H., Gonzalo Adolfo, and Mario A. L—pez M. networks and is starting to ßow into the road, 1996. ÒRepresentaci—n y proyecci—n tarifaria de empresas y otras consideraciones en torno a la legis- water supply, and other infrastructure sectors. laci—n de servios sanitarios.Ó (CompaniesÕ tariff pre- Such investment is allowing the economy to sentations and projections and other issues in water maintain high growth rates and the government and sanitation services legislation.) Universidad de to use its resources for social objectives. Users Chile, Departmento de Ingener’a, Santiago de Chile. have beneÞted from more and better services at Fischer, Ronald D. 1995. ÒEconom’a de las concesiones reasonable prices. Companies have increased viales en Chile.Ó (Economics of road concessions in Chile.) Universidad de Chile, Departamento de their productivity, earned fair returns, and Ingenier’a Industrial, Centro de Econom’a Aplicada, diversiÞed their operations in Chile and abroad. Santiago de Chile. Private participation in infrastructure has Galal, Ahmed, and others. 1994. Welfare Consequences of posed new challenges for the Chilean govern- Selling Public Enterprises: An Empirical Analysis. New ment. It has been moving away from managerial York: Oxford University Press. Jadresic, Alejandro. 1993a. ÒDesregulaci—n econ—mica: activities and has had to develop new regulatory avances y tareas pendientes.Ó (Economic deregula- skills. Just as private companies are modernizing tion: progress and impending tasks.) In Eugenio and becoming more competitive, the state is Lahera, ed., C—mo mejorar la gesti—n pœblica. (How to reshaping itself to incorporate the human improve public management.) Santiago de Chile: resources and technology required to ensure efÞ- Cieplan/Flasco Foro 90. cient private development in infrastructure. ÑÑÑ. 1993b. ÒLa transformaci—n de la producci—n, el crecimiento y la competitividad internacional en la Consequently, it is promoting administrative Regulating Private Involvement in Infrastructure 69

experiencia chilena.) Production transformation, Rojas Pinaud, Alejandro. 1994. ÒExperiencias de priva- growth and international competitiveness in the tizaciones en Chile: Lan Chile, Entel y CTC.Ó Chilean experience.) In Studies and Reports of the (Privatization experience in Chile: Lan Chile, Entel Economic Commission for for Latin America 84. and CTC.) Working paper 2. Universidad Adolfo Santiago de Chile. Ib‡–ez, Instituto de Econom’a Pol’tica. Melo, JosŽ Ricardo, and Pablo Serra. 1996. S‡ez, Raœl E. 1993. ÒLas privatizaciones de empresas ÒCompetencia y regulaci—n en telecomunicaciones: en Chile.Ó (Privatization of companies in Chile.) In La experiencia chilena.Ó (Competition and regula- Oscar Mu–oz, ed., DespuŽs de las las privatizaciones: tion in telecommunications: the Chilean experi- Hacia un estado regulador. (After privatization: ence.) Universidad de Chile, Departamento de toward a regulatory state.) Santiago de Chile: Ciencias F’sicas y Matem‡ticas, Santiago de Chile. Cieplan. Paredes, Ricardo. 1995. ÒEl sector elŽctrico y el merca- Superintendencia de Servicios Sanitarios. 1996. do de capitales en Chile.Ó (The electric sector and ÒMemoria anual 1995.Ó (1995 annual report.) capital markets in Chile.) Paper LC/R 1496. Santiago de Chile. Santiago de Chile: Economic Commission for Latin America.

5 Managing Environmental and Resettlement Risks and Opportunities in Infrastructure Bradford S. Gentry

overnments struggle to attract private them capture the opportunities to address key investors to infrastructure projects and issues through private involvement? Before Gto address the problems created by unre- addressing this question governments must rec- solved environmental or resettlement issues. ognize that their role has changed, but not been Private investors are acutely aware of the Þnan- eliminated or diminished in importance, and cial risks to infrastructure projects posed by envi- that affected communities need to be incorpo- ronmental and resettlement concerns. Examples rated into the risk mitigation process. of how these problems can affect private invest- Governments should then follow Þve basic ment in Asian infrastructure abound in the steps for managing environmental and resettle- power, water, and transporatation sectors.1 ment risks and opportunities: The risks associated with environmental and ¥ Identify risks and opportunities through resettlement issues reduce the attractiveness of environmental assessments (including reset- infrastructure projects. But these problems can tlement issues) and investor due diligence. also create opportunitiesÑfor governments to ¥ Assess the relative Þnancial importance of improve local environmental and social condi- particular risks and opportunities. tions cost effectively and for private investors to ¥ Take advantage of opportunities and miti- make money. Privately Þnanced water supply gate substantial risks through design of the and treatment plants can improve water safety, project, the environmental legal framework, and longer-term prospects of populations and the resettlement plan. affected by resettlement can be improved, for ¥ Allocate the residual risks to the parties best example. able to manage them (sponsors, govern- East Asian governments must consider two ments, development banks, private fundamental sets of questions as they strive to Þnanciers). reduce deterrents to private investment. First, ¥ Implement risk mitigation steps in a timely why are private investors concerned about envi- and effective manner. ronmental and resettlement risks? What legal, Environmental and resettlement risks can be operational, and political risks do environmen- managed and opportunities captured. They tal and resettlement issues pose to infrastructure must, however, be treated not as a special cate- projects? How do the impacts of those risks vary gory of problems but as key objectives. across different types of infrastructure projects depending on their location, design, construc- Environmental and resettlement risks as tion, operation, secondary impacts, and political deterrents to private investment sensitivity? Second, what steps can governments take to make private investors more com- The goal of any private investor is to Þnd deals fortable with the level of environmental or that offer predictable and acceptable returns. In resettlement risk facing a project and to help the infrastructure sector this search is compli-

71 72 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 5.1 Public opposition to the Bakun hydroelectric project in Malaysia complicates financing The $5.5 billion Bakun hydroelectric power project has long fer had the effect of eliminating plaintiffs’ right to participate in been opposed by environmental and other NGOs. The dam the EIA process. The court ruled that Ekran, the developer of is designed to provide 2,400 megawatts of power to peninsu- the project, had to comply with the national act before it could lar Malaysia through a 650-kilometer long undersea cable from build the dam. The decision has been appealed to a higher the state of Sarawak on the island of Borneo. Located deep in court. the jungle, the dam would reportedly flood an area the size of The project is proceeding (the plaintiffs’ request that an Singapore and force more than 9,000 local tribespeople to injunction stopping work be issued was denied by the Appeals relocate. Court). But the search for financing (a large part of which is Although the Sarawak government offered to provide new reportedly to be secured by floating shares in the dam’s oper- homes or more than $120 million in compensation to those ating company) has been made more difficult by the suit, and being moved, three of the people to be relocated filed suit, financial analysts believe that the legal issues must be resolved challenging the government’s approval of the EIA for the pro- before financing can take place. In addition, ABB, the con- ject. struction contractor for the dam, has been the subject of a peti- In its ruling the High Court found that the national gov- tion drive by more than 100 NGOs and 30 members of the ernment had violated the National Environmental Quality Act European Parliament seeking its withdrawal from the project. by transferring responsibility for approving the EIA to the state Friends of the Earth has also said it will step up its lobbying of authorities in Sarawak (a shareholder in the project). investors in ABB and Ekran. Differences in federal and state procedure meant that the trans-

cated by the long timeframes over which returns Types of environmental and resettlement are earned and the ÒpublicÓ nature (and hence risks political sensitivity) of the services provided. The level of risk inherent in such long-term, sen- The environmental and resettlement risks facing sitive investments leads Þnanciers to address as any project fall into three main categories: legal, many signiÞcant risks at the outset as they can. operational, and political. Environmental and resettlement issues can create enormous uncertainty for investors. They Legal risks can increase completion risk through delays, failure to obtain necessary authorizations, and Legal risks arise when a project is not in compli- cancellation in the face of public opposition. ance with all applicable procedures and stan- They can increase project risk by increasing con- dards, including both local laws and the struction or operating costs, reducing future rev- contractual requirements of investors. If the pro- enue streams, or decreasing the value of ject does not meet local requirements, it may be collateral. In extreme cases they can pose direct subject to delays, enforcement, lawsuits, closure, risks to Þnanciers through liability or the com- or cancellation. If the project does not meet both mercial impact of international protests. local and investor requirements, its chances of Public opposition to infrastructure projects attracting international Þnancial support are because of environmental and resettlement con- substantially diminished. cerns is now Þnding its way into the courts in National environmental requirements are East Asia, further increasing uncertainty for often extensive, with regulations setting envi- investors. In June 1996 the Kuala Lumpur High ronmental assessment procedures, project siting Court ruled that the governmentÕs approval of approval processes, environmental standards for the environmental impact assessment (EIA) for project operation, and liability for environmental the Bakun hydroelectric project in Sarawak was damage. National resettlement requirements in illegal (box 5.1). Delays to the project would cost East Asia tend to be less developed than else- almost $4 million a day, according to the chair- where, and many countries in the region lack man of the project company. adequate laws on compensation for taking of private lands or fail to enforce them. Only one coun- Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 73

Box 5.2 The World Bank’s pollution prevention and Box 5.3 World Bank criteria for resettlement plans abatement handbook The World Bank’s directive on involuntary resettlement In 1995 the World Bank released a draft handbook [TITLE?] (OD 4.30) applies to Bank support of infrastructure projects on the environmental performance of the industrial projects that use public eminent domain powers to acquire land, it supports. Commonly referenced by public and private whether private investors are involved or not. It includes the international financiers, the handbook includes suggested following list of factors to be addressed by governments: emission limits for different types of projects. The limits for • Organizational responsibilities thermal power stations, for example, cover air emissions, • Valuation of and compensation for lost assets liquid effluent, and solid waste. Recommended monitoring • Identification of vulnerable groups • Resettlement finance and budgeting • Community participation • Land tenure, acquisition, and transfer try in the region (China) has a legal framework • Integration with host populations for addressing the broader social issues created • Training, employment, and credit by involuntary resettlement. • Socioeconomic survey The search for support from multilateral • Shelter, infrastructure, and services development banks brings with it the need to • Legal framework meet additional environmental and resettlement • Environmental protection and management • Alternative sites and selection requirements, such as those implemented by the • Implementation schedule and monitoring. World Bank (Operational Directives 4.01 on environmental assessment, 4.20 on indigenous peoples, and 4.30 on involuntary resettlement). Even more important is the growing number These requirements have been adopted, in large of commercial bankers and underwriters who part, to address the criticisms leveled by envi- look beyond local law to international standards ronmental NGOs and others over the develop- on environmental and resettlement issues. The ment banksÕ historical lack of sensitivity to starting point for a commercial bankerÕs analy- environmental and resettlement issues. sis is determining whether a project is in com- In some cases these standards parallel local pliance with local law, whether or not the law is requirements; in many cases they go beyond ever enforced in practice. In countries in which national laws. Included are guidelines for envi- enforcement is lacking, pressure from the Þnan- ronmental and resettlement review procedures, cial community to improve compliance repre- minimum environmental performance stan- sents a new and powerful inducement to meet dards (such as the 1995 World Bank local requirements at the outset of a project. ÒGuidelines,Ó described in box 5.2), areas to be Many bankers, particularly those from indus- addressed in resettlement action plans (box 5.3), trial countries, then consider compliance with and public notice and consultation. international standards, which is necessary Although some countries have raised sover- when development bank support is sought. eignty objections to the existence of international Even where such support in not sought, how- standards, their use is on the rise. The U.S. ever, compliance with international standards is Export-Import Bank (ExIm Bank) and the increasingly viewed as a useful defense in the Overseas Private Investment Corporation (OPIC) face of international protests over a private have adopted environmental procedures and investorÕs involvement in a particular project standards similar to those of the World Bank. In (see box 5.15). 1995 OPIC took steps to cancel the political risk insurance it had issued to Freeport-McMoRan Operational risks because of the scope of the environmental impacts from the companyÕs Irian Jaya copper Operational risks reßect the technical and man- and gold mine. Other national export credit agen- agerial capacity of the project team to meet the cies are under increasing pressure to follow the necessary standards. The level of risk depends lead of the ExIm Bank and apply similar stan- on the ability of the facility to meet applicable dards to their export assistance programs. standards at the commencement of operations 74 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 5.4 Environmental protests delay construction Box 5.5 Resettlement issues delay transport projects of light rail in Bangkok in Guangzhou, China Environmental protests have added to the delays and costs Guangzhou, southern China’s most prosperous city, has facing the already complicated efforts to build three mass attracted considerable private interest in transportation pro- transit lines to help ease Bangkok’s chronic traffic problems. jects, although resettlement issues have been a continuing Two of the lines have been sponsored by Thai developers source of controversy. Resettlement compensation was (Tanayong and Bangkok Land) and one has been sponsored raised as part of the city’s efforts to reach agreement with by a Hong Kong firm (Hopewell Holdings). Hopewell Holdings for the East-South-West Ring Road, a toll In response to public pressure to move underground road project that has been stalled by disagreements over to reduce noise and visual impacts, the Thai government investment costs. Significant delays have been experienced has imposed numerous conditions on the projects, includ- over the resettlement of more than 140,000 residents ing the commissioning of additional environmental studies affected by Metro subway line number one. and the increased use of underground routes. The farthest along project, Tanayong, has had to move its main depot to a new location as a result of environmental protests. also on the way it is handled. Problems can be Difficulties in resolving environmental issues and frequent exacerbated if the government and the sponsors changes in Thai government policy on transport projects do not demonstrate a willingness to understand have substantially increased the difficulties facing private and address local and international concerns, at investors in these projects. least to some degree. This is particularly true for resettlement issues. (Has it been properly designed? Does the equip- Public opposition can increase both comple- ment work as planned? Was the resettlement tion and project risks by (a) delaying a project, plan properly implemented?) and the ability of (b) raising project costs as a result of required the operator to provide reliable performance design changes, (c) increasing the possibility over time (Are trained personnel and manage- that the government will cancel the project, (d) ment systems in place? Are the required actions reducing the number of potential investors, (e) being taken?). Because operating companies impairing the operatorÕs ability to maintain or tend to be experienced, the level of risk can be collect adequate user fees, and (f) in extreme assessed by technical consultants, and contrac- cases, placing project facilities and personnel at tual protections and insurance can be secured, physical risk. Examples of some of these effects operating risks are usually less worrisome to can be found in transport projects in Bangkok, investors than legal or political risks. Thailand, and Guangzhou, China (boxes 5.4 and 5.5). Political risks Changes in the law, particularly in rules affecting a projectÕs financial performance, are Political risks, which include the risk of opposi- also a major concern to investors. Sometimes tion to the project and the risk of major changes referred to as Òcreeping nationalization,Ó this to the laws governing project construction or risk involves unanticipated changes by the operation, are usually the most worrisome to government to the rules governing the project private investors in long-term infrastructure that reduce the expected return to investors. Of projects. Public opposition is the most unpre- greatest concern are reductions in the level of dictable risk. Most of the other environmental fees charged to users. Protests over express- and resettlement issues can be efÞciently way tolls in Indonesian and Malaysian and addressed by project sponsors and the govern- sewerage fees in Malaysia have complicated ment if they are well managed and sufÞcient private sector involvement and lowered resources are marshaled. returns to investors (box 5.6). Unexpected Environmental and resettlement issues are tightening of the environmental standards or among the most likely to generate signiÞcant widening of the scope of resettlement efforts local or international opposition and press cov- may have similar effects by raising project erage. The intensity of the opposition depends costs. not only on the characteristics of the project but Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 75

Box 5.6 Protests over sewerage fees force rollback in Malaysia

Since it was awarded the national sewerage concession in Protests over the new sewerage charges began almost 1993, Indah Water Konsortium (IWK) has faced a storm of immediately. Commercial users of water found themselves protest over the fees it charges. The result has been govern- confronted with substantial bills for sewerage services, regard- ment-ordered reductions and substantial disruptions in getting less of the quantity or quality of their effluent. No correspond- the business up and running, both of which have fueled con- ing reductions in local rates were made, and no immediate tinuing protests over the lack of improvement in services. improvements in service were apparent to the public. Before the concession was awarded, sewerage services In response to the protests, the government reduced were the responsibility of 144 separate local authorities, and commercial fees over the first three years of the concession, in fees were included in the general local rates. Operational per- effect phasing in the new charges. Although this reduction qui- formance was poor and underinvestment in infrastructure was eted some of the public opposition, fee and service issues have a serious problem. As the government struggled to find an continued to dog IWK. In late May 1996 the company placed answer to the growing concern over sewage pollution, IWK full-page ads in all major newspapers announcing a complete proposed a national concession. The concession was approved review of its operations, including the possibility of further by the legislature, and a new regulatory framework was estab- reductions in fees. lished for IWK’s fees.

Effects of environmental and resettlement ber of people to be relocated. Air pollution con- risks on different types of infrastructure trol issues are most pressing for coal-Þred power projects stations, given the concerns over the impact of dust on local health; acid gasses on local health, The environmental and resettlement risks facing an investment depend on the following factors, which vary from sector to sector, project to pro- Box 5.7 Government fails to meet international ject, and location to location: (a) the sites chosen standards in dealing with relocation issues in Manila for both main and ancillary facilities; (b) the One of the major unresolved issues facing the EDSA Light design, including expected emissions and other Rail Transit Project in Manila (LRT 3) is the need to move at impacts; (c) construction; (d) operation of the least 17,000 squatters from the site on which a depot is to completed facilities; (e) secondary impacts, be built. A portion of the site has been cleared of commer- including opening up new areas to develop- cial premises through a series of lawsuits and eviction ment; and (f) political sensitivity over the type of notices. Efforts to relocate the squatters residing on the site began in the fall of 1995 and had not been resolved by 1996. service provided or project undertaken. The Part of the delay stems from the difficulty of finding accept- nature and intensity of environmental and reset- able sites for resettlement. The site preferred by the gov- tlement issues varies across types of infrastruc- ernment is twenty-five kilometers from the depot site and tur projects (table 5.1). relatively inexpensive. The other possible site is six kilome- Site selection raises a host of difÞcult issues, ters from the depot site, abuts a garbage dump, is more particularly for hydropower, highway, rail (box costly, and would require more time to prepare. Residents 5.7), and ancillary thermal power facilities, includ- have reportedly rejected the first site. The government’s approach to the resettlement prob- ing fuel source, fuel transportation, and power lem did not meet evolving international norms. In particular, transmission. The need to resettle residents is a the government failed to (a) undertake a comprehensive major factor in most of these cases. Flooding of socioeconomic survey, including a survey of residents’ atti- wilderness areas for hydropower facilities tudes on a wider range of resettlement options; (b) system- destroys forests and biodiversity. Cultural, reli- atically solicit public input on the resettlement plan; (c) gious, or archeological sites and wildlife areas consider acceptable resettlement alternatives, including may also be affected. All of these issues raise sig- those providing comparable access to employment, infra- niÞcant legal, operational, and political risks. structure, and services; and (d) offer measures to help protect the welfare of the affected families during and for a Plant design determines the environmental period after resettlement. impacts of facility operations as well as the num- 76 Choices for EfÞcient Private Infrastructure Provision in East Asia

Table 5.1 Relative importance of environmental risks to various types of infrastructure projects Thermal power Hydro power Renewable power Drinking water Sewerage Highway Rail Site selection Main facility ✓ ✓✓✓ ✓ ✓ ✓✓ ✓✓✓ ✓✓✓ Ancillary facilities ✓✓✓ ✓✓ ✓✓ ✓ ✓✓ ✓ ✓

Plant design Air ✓✓✓ ✓✓ Water ✓ ✓✓✓ ✓✓✓ ✓✓✓ ✓ ✓ Waste ✓✓ ✓✓✓ Noise ✓ ✓ ✓ ✓✓✓ ✓✓✓ Health and safety ✓✓ ✓ ✓ ✓ ✓ ✓✓✓ ✓✓✓

Construction Air ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓ Water ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓ Waste ✓ ✓ ✓ ✓ ✓ ✓ ✓ Noise ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓

Operations Management ✓✓✓ ✓✓✓ ✓ ✓✓✓ ✓✓✓ ✓ ✓ Health and safety ✓✓ ✓✓ ✓ ✓ ✓ ✓ ✓✓ Emergencies ✓ ✓✓ ✓✓✓ ✓✓ ✓✓ ✓✓

Secondary impacts ✓ ✓✓✓ ✓ ✓✓✓ ✓

Political sensitivity ✓✓ ✓✓✓ ✓ ✓✓✓ ✓✓✓ ✓✓ ✓✓

Note: Intensity of risk is indicated by number of checks.

Box 5.8 Japan and China work together to develop cleaner coal

A unique set of relationships is emerging between China and environmental impacts of its expanding power sector. Concern Japan as they struggle through the environmental and eco- that acid rain from China is damaging Japanese forests is grow- nomic implications of the rapid expansion of coal-ﬁred power ing. Japan is a leading exporter of air pollution control equip- stations in China. ment, and the Chinese market is potentially huge. Japanese The internal debate over increased coal use is intensifying companies are also seeking to participate in the growth of pri- in China. In March 1996 the federal cabinet released a report vate sector involvement in Chinese infrastructure and other to the National People’s Congress stating that the coal sector projects. must “accelerate production to meet the country’s increasing The result has been a number of “cleaner coal” initiatives energy demands.” In April 1996 the Chinese Ministry of Public in China sponsored by the Japanese government. As part of its Health and the State Science and Technology Commission “green aid” program, the Japanese Ministry of International reported that pollution was now a leading cause of illness and Trade and Industry has been demonstrating the use of lower- death in many Chinese cities and that air pollution, much of it priced ﬂue gas desulferization equipment in a small number of caused by the burning of coal, was of particular concern. Similar Chinese power plants. In 1996 the Japanese Overseas results from earlier studies led a Standing Committee of the Economic Cooperation Fund announced that it was focusing its National People’s Congress to call for much tighter controls on new special loan program to China on environmental projects, sulfur dioxide emissions in the fall of 1995. The government including cleaner coal usage, and formal agreement among was thus faced with the need to both increase coal production China, Japan, and Germany was expected on the cosponsor- and reduce air pollution, something it could achieve only by ing of a feasibility study for a coal liquefaction plant (expected to investing in air pollution controls. cost $500–$600 million). Japan has many reasons to try to help China reduce the Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 77

Table 5.2 Politically sensitive issues that can affect infrastructure projects Issue Types of projects particularly affected Resettlement of large numbers of people, particularly indigenous peoples Hydropower facilities, highway, and rail lines or squatters (box 5.1) Imposition of new or significantly increased user fees on “public” services Water supply or wastewater treatment, roads, electricity (box 5.6) Destruction of large areas of tropical forest or other sensitive habitats Hydropower facilities (box 5.14) Emission of large quantities of air pollutants affecting local, regional, and Coal-fired power stations global environmental conditions (box 5.9) buildings, and ecosystems; and carbon dioxide on global warming (box 5.8). Water quality Box 5.9 Public opposition to coal-fired power plants issues are critical to the operations of water and suspends construction in Thailand hydroelectric facilities. The need to dispose of During the 1990s a number of coal-fired power plants sewage sludge creates major waste issues for became the subject of environmental protests in Thailand. sewerage systems. Noise is a major factor in One of the earliest was the Mae Moh station, in northern transportation projects and presents at least Thailand. In October 1992 adverse weather conditions and some risk to most other projects as well. a malfunction at the plant created an air pollution event that caused hundreds of residents to require treatment for res- Construction generates signiÞcant environ- piratory problems. As a result the Electricity Generation mental impacts, which are usually temporary Authority of Thailand had to cut back production at the plant, and manageable by qualiÞed contractors. These reducing its already strained total generating capacity by 3 risks are thus largely operational risks. During percent. operations the quality of managementÕs imple- In early 1996 construction of an experimental power mentation of the environmental and resettlement station was suspended by the government following protests programs is key to the success of the project. by local residents. Designed primarily to burn municipal solid Failure to implement a well-designed operations waste, the plant had also planned to use coal for up to 40 percent of its fuel in its early years. or resettlement plan increases the risks to private investors. EmergenciesÑsuch as release of toxic materialsÑare a particular concern in drinking that increased private involvement in infra- water systems, where operational risks are usu- structure means that its role has only changed, ally the principal concern. Secondary impacts rather than been eliminated or even diminished range from the ancillary development spurred in importance, and that public involvement is by the opening of highways into new areas to the critical. While governments no longer have pri- increases in consumption of resources that often mary funding or operating responsibility, they accompany expanded access to power or roads. set targets and frameworks for private involve- These impacts generally increase legal risks in ment at the outset and have an ongoing respon- the structuring of the project or political risks sibility to monitor performance and apply over its life. frameworks in a predictable and consistent The political sensitivity of different types of manner over the life of the project. This changed projects is critical and affects all aspects of pro- role affects both project design and regulatory ject preparation and implementation. For pro- oversight activities. Effectively meeting these jects that have come under the public new responsibilities means that the government spotlightÑlocally or internationallyÑnew hur- and the private operator have to build a long- dles to project completion are erected (table 5.2). term working relationship based on clearly deÞned roles. While each has its own areas of Addressing the risks and taking advantage exclusive responsibilityÑwith the government of the opportunities posed by responsible for regulation and the operator environmental and resettlement issues responsible for technical performanceÑjoint action will be necessary on many issues, includ- All of these environmental and resettlement ing major resettlement issues. Since it is impos- issues can be managed once government accepts sible to anticipate and provide for all 78 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 5.10 Developing a good working relationship in Box 5.11 Working cooperatively on resettlement Buenos Aires: Aguas Argentinas and ETOSS issues in Calcutta Aspects of the 1993 privatization of the Buenos Aires water The original plan for construction of a 500-megawatt ther- system demonstrate the importance of clearly defined roles mal power plant on the outskirts of Calcutta required mov- and long-term working relationships. Clear standards of per- ing 200 families (800 people) from the site of the generating formance were established and a pricing structure that station and railway line. Representatives of the affected fam- encourages efficient operation was adopted. A regulatory ilies as well as of local, regional, and national government body, ETOSS, was created to oversee the activities of the bodies worked with the Rehabilitation Committee to facili- concessionaire, Aguas Argentinas, and a variety of proce- tate the planning and implementation process. As a result of dures are being used to resolve disputes between the par- their efforts the project was redesigned so that only 100 fam- ties. More important, however, as the concession goes on ilies had to be moved. The IFC provided financial and other each party is beginning to understand the other’s goals and support to the project, construction of which began in 1993. methods of operation more clearly. As the parties work through the wide variety of issues that arise through daily operations, a track record is being established that helps changes should be made to project design build trust. As Aguas collects and makes available to govern- requires judgment. ment authorities more data on regional environmental con- Although project sponsors may fear that ditions, the government is more likely to seek input from the informing the public may delay or even derail a company on regional environmental planning. While this project, experience has shown that done well may eventually raise questions of “regulatory capture,” it provides the parties with a basis for cooperating to resolve public outreach is the best way to minimize the problems they both face. risk of signiÞcant public opposition and saves time and money over the life of the project. In Calcutta, India, for example, an outreach program involving private investors successfully contingencies that may arise over the course of developed a resettlement plan (box 5.11). Some a twenty-year concession, the parties must multinational companies view public involve- develop a strong working relationship based on ment as the means of obtaining the Òsocial respect and understanding of each otherÕs goals. license to operate,Ó which they regard as just as Experience developing such working relation- necessary as any legally required permits. ships is now beginning to emerge from earlier Addressing environmental and resettlement privatization efforts, such as that in Buenos issues is a continuing process that involves both Aires (box 5.10). private and public parties. A Þve-step process Since public opposition is often the most consisting of identifying, assessing, minimizing, unpredictable and worrisome risk facing infra- allocating, and implementing can be adopted. structure projects, the public must be involved Activities in any one of these areas are affected in the risk mitigation process early and often. by activities in the others and usually proceed in Such involvement can provide early warning parallel. concerning project features that might lead to opposition, which could then be redesigned to Identifying potential environmental and minimize such risk, and help establish ongoing resettlement risks and opportunities relationships with the community, which allow the sponsor to monitor and respond to new The process of identifying environmental and issues as they develop. resettlement risks and opportunities must begin Public involvement is a sensitive, compli- at the earliest stages of project development, and cated, and uncertain process. In some countries it must continue throughout the life of the pro- public criticism of government-supported project. As new parties become involved in the jects is actively discouraged; in others there has transaction, they should be brought into the been little experience in soliciting public input. process. Once the government has identiÞed its Identifying and reaching the various groups to goals for the infrastructure investment, it should be consulted can be difÞcult. Deciding how undertake the initial analyses during prepara- much public involvement is enough and what tion of terms of reference. In the case of an unso- Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 79 licited bid, the sponsor should do so. Once the Box 5.12 Checklist of potential issues for an concession has been awarded, the process environmental analysis should continue jointly between the govern- The International Finance Corporation’s guidance to staff on ment and the sponsors, with the involvement of “Environmental Analysis and Review” identifies the following Þnanciers before closing. The project operator areas: should then carry the effort forward, with input • Agrochemical usage from the government and the affected public. • International waterways One of the Þrst steps will be the commission- • Biological diversity ing and execution of some form of EIA, often • Involuntary resettlement accompanied by or incorporating resettlement • Coastal and marine resource management • Land settlement issues (box 5.12). Such reviews are almost • Cultural properties always required under national law and by • Natural hazards development banks. Where private developers • Dams and reservoirs are involved, they are usually responsible for • Occupational health and safety preparing the EIA. Failure to conduct an ade- • Environmental guidelines quate EIA provides project opponents with a • Ports and harbors powerful device with which to delay the project, • Hazardous and toxic materials • Tropical forests as demonstrated by experiences in Malaysia, the • Indigenous peoples United States, and Europe. • Watersheds Once the EIA has been conducted, other • Induced development/sociocultural aspects types of risk of concern to private investors can • Wetlands be identiÞed. For legal risks all applicable • Major hazards requirements must be identiÞed and their likeli- • Wildlands. hood of being met assessed. Performing such an assessment requires both legal and technical skills and is usually handled by local and inter- The methods for identifying political risksÑ national law Þrms working closely with engi- particularly the likelihood of signiÞcant public neering consultants. In many countries it is oppositionÑare the least well deÞned, because difÞcult to Þnd local lawyers familiar with both the issues themselves are less clear. The Þrst step environmental requirements and the needs of is for international sponsors and lenders to private investors. As both local and interna- engage in a broad effort to try to understand the tional law Þrms gain experience with these country and its politics, goals, and needs. issues, however, these difÞculties are diminish- Sponsors then work with government ofÞcials ing. The sponsorÕs advisors usually take the lead to identify the risks facing a particular project. on these issues, subject to conÞrmatory analysis Public outreach is an extremely important by the lendersÕ advisors. part of this effort. Ideally, such efforts begin with Identifying operational risks requires assess- the EIA. The basic features of an outreach pro- ment of the technical and managerial capacity of gram include the following: the project to meet the required standards. The ¥ Identifying affected groups (both local and sponsorÕs personnel, working closely with its international) through contacts with govern- suppliers, will prepare a plan for doing so. Their ment, community, environmental, religious, plan is then reviewed by the governmentÕs tech- business, and other organizations nical consultants and then by technical consul- ¥ Providing notice of the proposed project, tants retained by the lenders. Many engineering including a project description, through Þrms are qualiÞed to review these plans, media bulletins, local project ofÞces, inter- although the different cost pressures facing the ested organizations, and community meet- design and operation of privately Þnanced facil- ings ities may make assessments difÞcult for con- ¥ Offering opportunities for concerned citizens sulting engineers whose only experience is on to submit comments on the project through public sector projects. written remarks, surveys, individual inter- 80 Choices for EfÞcient Private Infrastructure Provision in East Asia

views, focus groups, and public meetings resettlement issues is at the earliest stages of pro- ¥ Analyzing and developing responses to the ject design. By including environmental and comments received, by making changes to resettlement goals from the beginning, govern- the project or explaining why requested ments can bring private sector creativity to the changes will not be made design of cost-effective solutions. Private ¥ Disseminating the responses to the affected investors are most comfortable when clear groups through media bulletins, local project investment targets are presented and signiÞcant ofÞces, interested organizations, community risks can be eliminated through careful project meetings, and revised project descriptions development. ¥ Engaging in an ongoing process of providing In order to make the most of the project information and receiving public input on design phase, governments must pay special the project, through local project ofÞces, attention to their overall infrastructure goals mailings, community meetings, and citizen and the range of methods for meeting them, the advisory boards. environmental regulatory framework adopted for the project, and the plan to be developed and Assessing the signiÞcance of particular risks followed for addressing any involuntary resettlement issues. After environmental and resettlement risks and opportunities are identiÞed their signiÞcance to Infrastructure goals and alternative methods for the project needs to be determined. First, a rough meeting them. Government infrastructure plan- order of magnitude must be estimated for the ning has historically focused on large, high cap- Þnancial implications of each risk or opportu- ital cost facilities, often designed without nity. In some cases this is a relatively easy task; substantial attention to environmental or social in other cases assigning a Þnancial value is com- impacts. As governments seek to increase the plicated. For example, it is difÞcult to determine private sector role in such projects, they often the cost of the delays incurred as a result of dis- use these prior infrastructure planning efforts turbances at sites with local historical or reli- and assumptions as the basis for bids and other gious signiÞcance. Measuring and valuing these private involvement. impacts can be difÞcult. Doing so is necessary, By relying on earlier planning efforts, gov- however, to give both government sponsors and ernments often miss out on opportunities to private investors a basis for deciding whether or apply private sector resources and creativity to not to proceed with the transaction. the cost-effective attainment of environmental Second, the available estimates are compared and development goals. This is true for two with the value of the deal as a whole or the ulti- major reasons. First, only relatively recently mate costs to users. Although the cost of miti- have environmental and resettlement issues gating a risk or capturing an opportunity may begun to have a major impact on infrastructure seem large in absolute terms, it may represent an planning efforts. Second, while the private sec- insigniÞcant amount in the context of the over- tor can often meet many of the governmentÕs all deal. Calculating possible impacts on user infrastructure goals more cost effectively and fees or investorsÕ return allows sponsors and the more reliably, its ability to do so is severely con- government to decide whether or not to go for- strained if it is limited to working within the ward and to focus their efforts on those risks and conÞnes of early public sector plans. opportunities with the greatest potential impact To capture opportunities for improving envi- on the deal. ronmental or social conditions through private involvement, governments need to take two Capturing opportunities and mitigating risks steps. First, they should assign higher priority to during project design a wider range of environmental and resettlement goals. These targets can then be included The most effective time for governments and in the optimization process for developing alter- private investors to consider environmental and native approaches to meeting infrastructure Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 81 needs. Clean water is already a priority for most Box 5.13 Adopting a demand side management countries in East Asia. Greater priority should approach to energy efficiency in Thailand be given to increasing the efÞciency of power In 1991 Thailand became the first Asian country to adopt a use and controlling dust and acid gas emissions utility-sponsored demand side management (DSM) energy from thermal power stations. Opportunities for efficiency program. A 1995 review of the potential for invest- ancillary environmental beneÞts for highway ment in Thailand’s energy efficiency industry by the projects should be valued more highly. In cases International Institute for Energy Conservation documents of involuntary resettlement, alternatives that the wisdom of this initiative. minimize the numbers of people moved or max- On average Thai investments in increased energy effi- imize the social gains to those affected should be ciency cost less than half the price of new generating capacity for the same level of megawatts. An achievable DSM weighted more heavily. potential of at least 2,000 megawatts over the next decade If governments set environmental and social has been identified—25 percent of planned system expan- targets, private investors will respond with sion. As much as $2.3 billion in capital costs could be saved methods and prices for meeting them, providing if an aggressive program to capture 2,000 megawatts of peak governments with a measure of the cost of demand was in place. Foreign operators with extensive achieving these targets. Broader consideration experience with DSM programs in other markets (especially of environmental and resettlement goals will the United States) can readily bring this knowledge to bear in Thailand, helping to capture these opportunities. also help reduce the potential for local and international public opposition. In turn, this will expand the pool of potential international funding sources. Water Konsortium (the national sewerage Second, governments need to be willing and concessionaire in Malaysia) were able to able to consider a wider range of methods for design sewerage systems that met the per- meeting their goals. The clearer governments can formance standards set by the government be about goals and the more ßexibility they can for much less than estimated in earlier gov- leave the private sector to design methods for ernment plans. meeting them, the more likely the private sector ¥ Operating practices: Experience with coal is to come up with cost-effective solutions. washing in the United States and Australia Choosing among a range of options, however, demonstrates that substantial economic and requires a broader range of skills than that environmental beneÞts can be achieved as a demanded by the traditional approach of putting result of reduced ash content (reducing both a publicly designed power plant out to bid. transportation costs and emissions) and Allowing the private sector leeway in devel- increased combustion efÞciencies (China is oping solutions may lead to recommendations seeking to increase the amount of coal it on different aspects of projects: washes from 24 percent to 30 percent by the ¥ Types of projects: If the goal is to make 800 end of the century). megawatts of power available, a combined ¥ Financing packages: The $30 million grant offer to provide 700 megawatts of new gen- from the Global Environment Facility to the erating capacity with 100 megawatts of mea- Leyte-Luzon geothermal project in the surable energy conservation gains might Philippines is one example of the public better meet the joint power and environmen- Þnancing beneÞts that can accompany the tal goals at a lower cost. design of projects with an increased Òenvi- ¥ Locations for projects: It may be possible to ronmental incrementÓ (see box 5.8). reconÞgure the design of hydro facilities or The choice of projects still rests with the gov- transportation corridors in order to minimize ernment. Recognizing and making explicit the the amount of land affected or the need for trade-offs made in the Þnal selection of a project resettlement. is an important part of the process of minimiz- ¥ Technical designs: Both Aguas Argentinas (the ing public opposition. In some cases the impor- operator of the privatized water and sewer- tance of a particular project for meeting the age system in Buenos Aires) and the Indah governmentÕs goals must be made clear in order 82 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 5.14 Addressing the concerns of the international financial community over the Nam Theun hydroelectric project in the Lao People’s Democratic Republic The Nam Theun II project is designed to export 681 cial community. In most industrial countries, private investors megawatts of power to Thailand in return for much needed will not invest without development bank support; the World foreign exchange. Gross revenues to the Lao government are Bank cannot provide that support unless environmental and expected to rise from $10 million to well over $100 million a resettlement issues are addressed to its satisfaction. year (in constant 1994 dollars) over the twenty-five-year con- To address these concerns, the government needs to cession term, doubling foreign exchange earnings and increas- make clear why hydropower is critical to meeting the devel- ing GDP by 20 percent. opment needs of both the Lao People’s Democratic Republic The new dam would flood approximately 450 square kilo- and Thailand and why it opted to develop hydropower rather meters, 30 percent of which is forested and rich in biodiversity. than other sources of power, such as nuclear or coal-fired sta- In addition, 900 poor households would need to be relocated tions. from the reservoir area. Several thousand people in the catch- The project also needs to be designed to optimize eco- ment area, along the reservoir perimeter, and in the down- nomic and environmental/resettlement benefits over the long stream channel area would also be affected by the project. term. This will require a commitment by the Lao government These environmental and resettlement problems have to ensure implementation of the environmental and resettle- flamed local and international opposition to the project. ment programs. Efforts are underway to offset the loss of Environmental organizations have opposed the loss of forests forests in the flooded area with much greater protection of a on the Nakai Plateau; others have protested the resettlement larger forest preserve within the project’s catchment basin. In plans. The intensity of these objections has been increased by addition, a more extensive resettlement plan is being consid- the international spotlight on large hydropower projects in Asia ered that would allow the local population to share in the eco- (Three Gorges, Narmada, Bakun) as well as by the protests nomic benefits of the project. Taking such efforts together, the over implementation of the environmental mitigation plan for project may result in more effective protection of a large tract the Pak Mun hydro project in Thailand. of rain forest. The project is also financially risky. The projected cost is All of these issues are now under consideration by project equivalent to about 75 percent of the country’s 1994 GNP and sponsors and the government. Support for the project has neither the Lao People’s Democratic Republic nor the private been received from two international environmental NGOs sponsors (Transfield of Australia, Electricité de France, and (the Wildlife Conservation Society and the World Conservation Italian-Thai and Phatra Thanakit of Thailand) have the resources Union) and the possibility of involving United Nations to undertake the project alone. International finance is thus Development Programme’s local office in the outreach neces- necessary. Crafting a project attractive to international sary for development of the resettlement plan has been dis- financiers requires that environmental and resettlement issues cussed. be addressed in a manner acceptable to the international finan- to secure international Þnancial backing. The An ÒidealÓ environmental regulatory frame- proposed $1.2 billion Nam Theun II work for an infrastructure project consists of an hydropower project illustrates many of the integrated package of laws and contracts that issues facing efforts to increase private involve- speciÞes the following: ment in politically sensitive ÒspotlightÓ infra- ¥ Standards of performance (set in terms of structure projects (box 5.14). simple emission limits and other readily measurable factors) that leave the private Environmental regulatory frameworks. operator the ßexibility to determining how to Governments need to establish and work within meet the standards clear, predictable, and reliable frameworks for ¥ Relationship of current and future environ- overseeing private sector environmental perfor- mental performance standards to the level mance. Clear rules allow investors to price and and regulation of user fees, particularly in design projects to reßect environmental con- light of fees previously charged (or not) by cerns. Governments can then decide if the cost the government for such services of compliance is too high. If the rules are not ¥ Environmental review procedures to be fol- clear or if they are inconsistently applied, pri- lowed vate investors will assign a higher risk premium ¥ Administrative procedures to be followed by to environmental issues, resulting in higher than the government in deciding on authoriza- necessary project costs. tions for the project, including mechanisms Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 83

for contesting aspects of the governmentÕs Box 5.15 Meeting the environmental standards of decision the U.S. Export-Import Bank: The Paiton I ¥ Monitoring, reporting, and inspection proce- (Indonesia) and Sual (Philippines) power projects dures to be followed, including the role (if Two large power projects were financed with the help of the any) of the public and NGOs international financial community. No significant public ¥ Sanctions to be applied in the event of non- opposition to the projects was raised and all of the interna- performance or environmental damage, tional institutions involved were satisfied that environmental including identiÞcation of all parties that standards had been met. may impose the sanctions, the procedures for The $2.5 billion Paiton I project involves two baseload doing so, and the mechanisms for contesting 615-megawatt coal-fired power units in northeast Java, Indonesia. The U.S. Export-Import Bank (U.S. ExIm) pro- the sanctions vided political risk cover for a $540 million loan. The U.S. ¥ Remedies available to the private operator, if Overseas Private Investment Corporation (OPIC) provided any, in the event the government changes $200 million in financing. The $1.35 billion Sual project environmental standards in the future. involves a 1,200-megawatt coal-fired station in the Given such a framework private investors Pangasinan province of the Philippines. U.S. ExIm guaran- can build environmental considerations into teed more than $370 million in debt, and the International project design, internal environmental manage- Finance Corporation (IFC) provided both direct loans and syndication of commercial bank debt. ment systems, community outreach programs, U.S. ExIm, OPIC, and IFC all apply their own proce- subcontracts with suppliers, insurance, and dural and substantive environmental standards to the pro- other project components. jects they support. In addition, two of the commercial banks Requiring private investors to meet such involved in these deals—Chase Manhattan and Citibank— standards need not mean that projects will be confirmed that they look to such “world” standards for com- too expensive or will fail to attract investors. In fort as part of their due diligence on the environmental risks fact, two of AsiaMoneyÕs 1995 Project Finance facing power projects. Òdeals of the yearÓ were power stations that successfully met the environmental standards affected by the project applied by both the national governments and ¥ Monitoring and supervision of implementa- the U.S. Export-Import Bank (box 5.15). tion of the resettlement plan ¥ Mechanisms for resolving disputes on reset- Resettlement plans. Reducing the risk of pub- tlement matters, including those between the lic opposition through fair and equitable treat- government and the affected people and ment of the affected populations should be the those between the government and the pri- cornerstone of risk management from a projectÕs vate sponsors or investors. inception. Minimizing risks to investors goes Where truly voluntary resettlement (wholly hand in hand with minimizing risks to people consensual purchases of the necessary land at affected by the project. open market prices) is involved, the private The process should begin with a clear deÞn- sponsors of the project will be able to take the ition of the tasks and responsibilities assigned to lead in relocating the affected parties. Where different parties in the deal. This can be done involuntary resettlement is involved, however, though a combination of national laws and con- governments need to take the lead, especially in tracts. The resulting package of responsibilities cases involving involuntary resettlement of should cover the following areas: large numbers of people, including squatters ¥ Preparation of the resettlement plan, includ- and indigenous peoples. Private investors are ing the items to be covered and standards to less equipped to handle involuntary resettle- be followed in doing so ment issues because they are often unfamiliar ¥ Acquisition of the land to be taken for both with local conditions and lack credibility among the project and the relocated people the local population. Moreover, the political ¥ Relocation of the affected people risks of leaving involuntary resettlement in pri- ¥ Economic rehabilitation of the affected peo- vate hands are considerable and could increase ple, both those relocated and those otherwise the level of resettlement payment. 84 Choices for EfÞcient Private Infrastructure Provision in East Asia

Box 5.16 Major findings of the World Bank resettlement review Involuntary resettlement is almost always more difficult, more ductive areas created by the project, favoring them in expensive, and more time consuming than governments project hiring and ancillary developments, and assist- expect, according to the World Bank (1994). Several factors ing them in building improved housing will help miti- appear to explain the differences between successful and gate the adverse effects of these people. unsuccessful resettlement efforts: 3. Accurate costing and financing: Poor performance on 1. Strong political commitment: The adoption of legal resettlement was often traced to inadequate eco- frameworks and guidelines (regional or sectoral) for nomic analysis, externalization of re-establishment resettlement is an early expression of political com- costs onto the affected population, and underfinanc- mitment. Conscientious and timely implementation ing. In the twenty cases reviewed, resettlement costs of those rules (particularly the payment of compen- averaged 9 percent of appraised costs and went as sation or provision of replacement land) confirms that high as 35 percent. commitment. 4. Participation of the affected parties: Outreach is criti- 2. Focus on income restoration: Creating the conditions cal to inform affected populations of the possible for successful income restoration is critical to reset- need to resettle and to obtain their input on sustain- tlement efforts. Achieving this goal is enhanced when able solutions to resettlement. Doing so often sub- the affected parties share in the immediate benefits of stantially decreases the likelihood of major public the project. Moving affected parties to newly pro- opposition.

International investors are extremely reluc- leading voluntary resettlement efforts at negoti- tant to commit Þnancing to a project until invol- ated market prices. untary resettlement issues are addressed, even if These and other experiences with involun- the government provides complete cover for the tary resettlement suggest that the government Þnancial risks posed. For example, at least one needs to develop and implement, with input international investor active in power projects from affected parties, a resettlement plan that has decided not to pursue the Ib Valley project addresses public concerns while meeting gov- in India, in part because the new project has revi- ernment and investor goals. To do so, the gov- talized old, unresolved resettlement claims in ernment should take the following steps: the area. ¥ Coordinate development of and commit to The forcible clearing of a site by the govern- implementing a comprehensive resettlement ment is not likely to address international plan (with support from private sponsors). investorsÕ concerns, particularly when viewed ¥ Begin community outreach as early as possi- over the life of a long-term concession, because ble, preferably before a Þnal siting decision is of the increased likelihood of up-front delays made, and involve local groups in the com- and negative publicity for the project, the cre- munities the affected people will be moving ation of local ill-will (and the possible effect on from and to. the future level and collection of user fees), and ¥ Consider how to address the different needs increased long-term risks to project facilities, of the parties being relocated, particularly particularly along lengthy corridors. property owners, squatters (including later Lessons from government efforts to address waves of squatters), and indigenous peoples. the risks of involuntary resettlement can be ¥ Develop plans to address both the replace- found in the World BankÕs 1994 resettlement ment of housing (either directly or through review, in which the Bank reviewed resettlement payment of compensation) and long-term experience in 192 projects it Þnanced between income restoration (through jobs on the pro- 1986 and 1993, with a combined displacement of ject and training, for example). 2.5 million people (box 5.16). The International ¥ Seek opportunities to upgrade local infra- Finance Corporation (IFC) conducted a similar structure, housing, landscaping, and similar review in 1995. Interestingly, the IFC had been amenities as part of the resettlement pack- involved in only seven resettlement projects, age. affecting only about 2,500 people. Virtually all of ¥ Establish adequate mechanisms for recourse the IFCÕs projects involved private sponsors by affected parties that wish to challenge the Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 85

government action. Box 5.17 Resettlement lessons from China ¥ Prepare complete and accurate cost estimates In its 1994 review of government-sponsored resettlement for the full resettlement plan. efforts, the World Bank concluded that “resettlement in ¥ Secure adequate Þnancing (from both public China is now generally considered to work well and even and private sources) for different compo- adds to project beneﬁts” (page 4/16). Four major reasons nents of the plan. were given by the Bank for this apparent success: ¥ Adopt community-based mechanisms for 1. Incentives: Resettlers receive strong incentives to monitoring and implementing the plan. move, ranging from increased living space to sig- Once the government takes these steps, pri- niﬁcant compensation payments. vate parties can make technical, operating, and 2. Decentralization: Responsibility for resettlement, including development and implementation, is at Þnancial support available for different parts of the local or city government level. the plan at different times. 3. Institutional policies and procedures: China has adopted binding policies and procedures for agri- Allocating residual risks to the parties best able to culture, energy, and urban development projects, manage them expenditures on which are reviewed by national auditors. While the goal of risk management is to elimi- 4. Giving resettlers a stake: Resettlement efforts hinge on providing productive resources to new com- nate as many risks as possible during design, munities, with many communities using the signiÞcant risks always remain. Residual risks opportunity to launch new enterprises they previ- need to be allocated to the parties in the best ously could not afford. position to manage them. This is usually done through the contracts that comprise the project and Þnancing documents. Environmental and resettlement risks are pated risks also needs to be in place. Much of the allocated among the government, project spon- success of such efforts will stem from the qual- sors (including their subcontractors), develop- ity of the relationship established between the ment banks, and private investors (table 5.3). government and the sponsors. In addition, the Different parties are best able to manage par- contracts and regulatory framework should ticular risks. Private parties are well positioned spell out clear mechanisms for identifying key, to address risks involving technical and opera- unresolved issues, resolving issues at higher lev- tional issues and to provide support for com- els of management, and using arbitration or munity relations activities. Governments are other mechanisms to resolve outstanding issues. best placed to bear political risks, including the risks associated with many aspects of resettle- Implementing risk management programs ment. Development banks can provide technical assistance and direct support in the event of sig- From a private investorÕs perspective, failing to niÞcant international public opposition as well implement a risk management program is just as as guarantees of government obligations under bad as not having developed a plan in the Þrst certain circumstances. Private Þnanciers are place, as it gives opponents grounds on which to extremely risk averse and will want essentially attack the project. Protests over the performance all project risks allocated to other parties before of the Pak Mun hydropower project in Thailand providing funding. After the deal is signed, pri- (including the alleged negative impact on the vate Þnanciers will monitor only those issues Þshing industry and the poor implementation of having an obvious and direct impact on bor- the environmental mitigation plans) demon- rowerÕs Þnances or a potential impact on their strate these difÞculties. other operations. However these responsibilities are allocated, assignment of risk needs to be Conclusion clear. Risks should not remain unaddressed because they were unassigned in the contract. The environmental and resettlement issues A clear process for responding to unantici- associated with infrastructure projects repre- 86 Choices for EfÞcient Private Infrastructure Provision in East Asia

Table 5.3 Responsibility for residual environmental and resettlement risks Risk Host country Sponsor Development banks Private ﬁnanciers Meeting legal standards Environment 1 3 Resettlement 1 2 3 Operational Technical 1 Managerial 1

Political Local opposition 1 1 2 3 International opposition 1 1 2 3 Fee collection 1 2 2 (if guaranteed) 3 Change in law 1

Note:1= party usually takes the lead in addressing or bearing risk 2= party often bears a portion of the risk and works actively to address it 3= party usually provides technical support on or actively monitors the level of the risk borne by other parties sent both risks and opportunities. The challenge activity aimed at meeting environmental and facing governments is to bring the power of the social targets. Private companies will meet only private sector to bear on priority environmental those targets that have a signiÞcant impact on and social issues. For many government ofÞ- their commercial interests. If governments set cials this will require a change in the traditional targets but have no basis for evaluating private view that economic development and environ- proposals to meet them, the effort will fail. mental protection are fundamentally inconsis- Effective mechanisms for monitoring perfor- tent with each other. This view leads to efforts mance must also be in place. to exclude environmental considerations from Setting, evaluating, and enforcing targets for the goals of development policies, including private sector activity are among the core activi- planning for infrastructure projects. The result ties of governments in their changed role in infra- is projects that lack clear guidance for investors structure. Including environmental and on environmental issues and that are more resettlement considerations among the priority likely to attract public opposition. Similar prob- factors to be optimized during infrastructure lems often accompany resettlement issues, par- planning will help ensure that opportunities are ticularly where indigenous peoples or squatters captured, risks mitigated, private investment are affected. increased, and development beneÞts maximized. The Þrst step in meeting this challenge is to convince development ministries that it is in Notes their best political interest to take environmental and resettlement issues seriously from the 1. Example include the Bakun and Nam Theun II very beginning of infrastructure planning hydropower projects, the Malaysian sewerage concession, and the Bangkok and Manil light rail projects. efforts. Doing so can improve the health and productivity of local citizens, reduce the uncer- taintiesÑand hence costsÑfacing private References investors, and extend the efÞciency gains from private involvement in infrastructure services. International Institute for Energy Conservation. 1995. Private investors will participate in projects with ThailandÕs Energy-Efficiency Industry: Potential for Investment. Washington, D.C. a higher environmental or social content if the World Bank. 1994. Resettlement and Development: The targets are clear. Governments will know the Bankwide Review of Projects Involving Involuntary true costs of such alternative approaches only if Resettlement. Washington, D.C. they solicit bids based on meeting environmen- ÑÑÑ. 1995. Mainstreaming the Environment. tal and resettlement targets. Washington, D.C. The second step is to build the capacity of governments to evaluate and oversee private 6 Financing Private Infrastructure: Lessons from India

Montek S. Ahluwalia

he infrastructure requirements of East and fewer private sector projects are currently being South Asia are very large and are increas- Þnanced than are feasible with current levels of Ting rapidly because of strong economic resource availability. In other words, the opera- growth. Countries throughout the region have tive constraint is not the level of resource avail- recognized that the public sector is unlikely to ability but the ability to structure projects in a mobilize the required resources and that the pri- manner suitable for private Þnancing. vate sector must be brought in as a supplemen- This chapter examines the reasons why so tary source of Þnance. Private sector many developing countries have experienced participation in infrastructure is desirable not difÞculties in implementing private sector infra- only to ensure a larger ßow of resources but also structure projects. It focuses on problems asso- to introduce greater efÞciency in the supply of ciated with (a) the fact that infrastructure these services. projects are generally subject to tariff regulation, The explosion of global capital markets and which presents special problems for private the associated expansion of private capital ßows investment; (b) the nature of the risks associated to emerging market economies provides new with infrastructure projects and the consequent opportunities to Þnance infrastructure projects need for complex risk mitigation arrangements in these countries, provided projects can be to ensure Þnanceability; and (c) the need to made commercially viable. Several experienced mobilize a suitable mix of Þnance, especially international companies are interested in invest- long-term Þnance, which is not easily obtained. ing in infrastructure development in Asia provided the overall investment climate is The problem of tariff determination perceived as attractive, and many countries in the region have domestic entrepreneurs keen to Tariffs on all infrastructure projects are regu- enter these sectors. lated; private operators are not free to Þx or Despite these apparently favorable circum- adjust tariffs at will. The tariff is typically Þxed stances, the experience in introducing private in advance and adjustable over time only in investment into infrastructure development has accordance with predetermined contractual been mixed at best. There have been some terms. Private investment can be attracted into a notable successes in East Asia, but the pace of tariff-regulated sector only if investors are con- implementation in many countries, especially in vinced that tariffs will be set and periodically South Asia, has been much slower than was ini- adjusted in a manner that ensures an adequate tially expected. Interestingly, the slow pace has rate of return to investors. Equally important, not reßected the lack of private capital. the public utility character of infrastructure pro- Although the resources available are probably jects requires that the tariff be perceived as ÒfairÓ inadequate to meet all of the infrastructure to consumers. This balance is not always easy to needs of the region, which are indeed enormous, strike, and disputes over tariffs can delay project

87 88 Choices for EfÞcient Private Infrastructure Provision in East Asia implementation. Some of the alternative ways of The internal rate of return on equity, which takes Þxing remunerative tariffs, and the problems account of the lack of return during the con- associated with them, are discussed in the fol- struction period, is therefore much lower. lowing sections. Private power producers have accepted this formula only because the operational efÞciency Cost-based tariffs norms used in computing variable costs are relatively lax and most private power producers The traditional approach to Þxing tariffs that are expect to improve on these norms, thereby both remunerative and reasonable is to tie the achieving internal rates of return of more than 20 tariff to normative levels of costs per unit for percent. The formula has been criticized on this given levels of capacity and production. These count as being nontransparent. cost-based tariffs cover capital costs on the basis Cost-based formulas are generally vulnera- of approved levels of capital expenditure and ble to the criticism that the approved capital variable costs on the basis of speciÞed parame- costs are excessively high or the efÞciency norms ters of operating efÞciency. They also include a excessively lax. There is no transparent way of component for return on capital, which is cali- countering this criticism. Estimates of capital brated to yield an acceptable rate of return to costs are especially difÞcult to defend against investors at a reasonable level of capacity uti- suspicion of cost padding or Ògold platingÓ of lization and operating efÞciency. Cost-based tar- capacity. This problem is especially acute when iff formulas generally include explicit equipment suppliers belong to the project spon- provisions for adjustment of tariffs over time to sor group. Comparison with costs of other pub- reßect rising prices.1 This cost-based approach lic sector projects is one way of determining to utility pricing has been used to price electric whether costs are appropriate, but such com- power supplied by independent producers to a parisons ignore differences in technology and monopoly distributor. It has also been used to quality. For example, high capital costs in pri- determine tolls for roads, bridges, and bypasses. vate sector power projects may be associated The cost-based approach has many prob- with greater fuel efÞciency, which reduces the lems. From the point of view of the producer, the power tariff. All these issues, as well as issues attractiveness of the tariff depends on whether connected with risk mitigation, have surfaced in the rate of return on equity generated by apply- one form or another in the public debate over the ing the cost-based formula is sufÞciently remu- cost of private power in India (box 6.1). nerative for investors. Experience suggests that private investors in infrastructure projects in Fixing tariffs through competitive bidding developing countries typically expect rates of return on equity of 20Ð25 percent. This is much An alternative approach to Þxing tariffs is higher than the rates of return normally used for through competitive bidding. Relevant techni- determining public sector tariffs. China initially cal and production characteristics of the project capped rates of return in the power sector at 15 are speciÞed in advance, and qualiÞed bidders percent, deterring many investors. The cap has are asked to bid in terms of the lowest tariff at since been relaxed. In India the rate of return which they would be willing to undertake the normally used to Þx tariffs for public sector project. As in the case of cost-based tariffs, these power producers is 12 percent after tax. In order tariffs have to be adjusted over time to reßect to attract private investment the return on inßation, and the manner in which this adjust- equity was raised to 16 percent at 68.5 percent ment will be made must be speciÞed in the invi- capacity utilization, with incentives that yielded tation to bid. Under this approach cost padding additional returns of 10Ð12 percentage points for is not a problem, and there is a transparent way capacity utilization of 85 percent. However, in of determining the lowest tariff at which the pro- the Indian tariff formula these rates of return ject can be implemented. If existing public sec- accrue only from the date of commercial pro- tor suppliers are also allowed to bid duction; no return accrues during construction. competitively, the approach establishes a level Financing Private Sector Infrastructure 89

Box 6.1 India’s experience with the power sector India announced a new policy for attracting private sector than public sector players had. Private investors investors in power generation in 1992. The policy envisaged looked for exchange risk protection, assured off-take bulk sale of power to the State Electricity Boards (SEBs) at of power subject to plant availability, protection negotiated rates based on a cost-plus formula. A large number against fuel supply risk, and other risk mitigation of Memoranda of Understanding were signed, involving schemes. These special features were criticized in the 80,000 megawatts of additional capacity. Implementation has public debate as being excessively favorable to private been much more modest. sector projects. Problems of tariff determination and risk mitigation proved • The first power project sponsored by the Enron more complex than envisaged at the time the policy was Corporation at Dabhol in the State of Maharashtra announced: ran into a series of hurdles, including renegotiation of • The cost-plus formula was perceived as being vul- the initial agreement, because of a change in the state nerable to padding of capital cost. The same formula government. It also faced several legal challenges in had not attracted criticism earlier, when both gener- public interest litigations, including challenges of the ating stations and distributors were in the public sec- validity of environmental clearances. Fortunately, tor, but the formula was felt to be unacceptable when these obstacles, including twenty-five court cases, applied to private sector projects. It became evident have been overcome, and the project is currently that much higher levels of due diligence are expected under construction. when there is a public-private interface. The govern- The complexities involved in achieving financeable pack- ment has since announced that future projects will be ages for private sector power projects were not adequately awarded on the basis of competitive bidding. appreciated at the outset. As a result, resolution of problems, • The policy did not originally envisage any guarantees involving interaction with several government agencies, took by the central government, but many private time. The government ultimately appointed a high-level board investors were unwilling to accept assurances of pay- consisting of senior representatives of the various ministries ment for power purchased by the SEBs because of involved to resolve problems. their poor financial condition. Moreover, they were Progress has recently accelerated. The 700-megawatt not satisfied with guarantees given by the state gov- Enron project at Dabhol is under construction, and two power ernments and insisted on counterguarantees from projects have actually started generating power (the 235- the central government. The central government megawatt GVK project at Jegurupadu in Andhra Pradesh and ultimately decided to extend such counterguarantees the 208-megawatt Spectrum project at Kakinada in Andhra for the first eight private sector projects. Pradesh). • Private investors sought much greater risk mitigation

playing Þeld for the private and public sectors impose certain conditions with which all bid- and thus ensures least-cost supply for individ- ders must comply. However, it is important to ual plants. High rates of return realized by avoid overspecifying technical details to the investors in a competitive bidding framework point of foreclosing technology choices, which need not attract controversy, since the bidding are best made by private investors searching for process ensures that the tariff is the lowest pos- least-cost solutions. sible. High returns under these conditions can Competitive bidding also has its limitations. only reßect increased efÞciency, which should be A bidding process will yield the lowest cost encouraged. option only if enough qualiÞed bidders actively One limitation of the competitive bidding compete. In practice the number of bidders for approach is that transparency in bidding an infrastructure project may be limited, for sev- requires full speciÞcation of the minimum tech- eral reasons. Lack of information and clarity nical requirements of the projects, which calls about various aspects of government policy rel- for considerable advance work before bids are evant to the project may deter many eligible bid- solicited. Certain characteristics of the project, ders from bidding. This may occur if the legal, including basic technical speciÞcations and the Þnancial, and technical requirements of the pro- expected level of guaranteed supply, must be ject are not spelled out in advance or there is lack speciÞed. Environmental regulations may also of conÞdence that the integrity of the bidding 90 Choices for EfÞcient Private Infrastructure Provision in East Asia process will be maintained (that is, the predeter- or set up new competing ports, subject to a com- mined requirements will not be changed after mon tariff Þxed by a regulatory agency. The bids have been solicited). In such situations Þx- Jawaharlal Nehru Port Trust in India has recently ing tariffs through competitive bidding could awarded a $200 million port expansion, involv- produce an outcome inferior to that that could ing private sector construction and operation of have been achieved through negotiations. An two new container terminals, to an Australian- International Finance Corporation study (1996) Malaysian joint venture through competitive bid- comparing tariffs in different power projects in ding on the basis of revenue sharing. Indonesia concluded that there was no evidence The license fee or revenue-sharing approach that tariffs arrived at through competitive bid- can be adopted wherever the licensee can make ding were lower than tariffs Þxed through nego- sufÞcient proÞt to be able to offer a license fee or tiation. The experience in the Philippines leads a share in revenue. In other situations, such as to the opposite inference. Tariffs in the earliest construction of toll roads with low trafÞc pro- power projects, which were set on a negotiated jections in the initial years, it is not possible to basis, were as high as 8 cents a kilowatt hour; tar- ensure proÞtability with any plausible tariff for iffs on the later projects, which were competi- many years. In such cases private sector invest- tively bid, were as low as 5 cents a kilowatt hour. ment is possible only if returns to investors can In the Þnal analysis the relative merits of Þx- be enhanced. The simplest solution is to offer an ing tariffs through competitive bidding or nego- operating subsidy, or an upfront capital subsidy, tiation will depend on the quality of the bidding with the subsidy determined by investors bid- process in the one case and the quality of the ding competitively for the lowest subsidy. A sec- negotiating process in the other. Negotiation ond approach is to bundle an existing public may well yield a better outcome in some cases, sector asset into the concession to increase the but competitive bidding is more transparent, an proÞtability of the new investment. In India, for overwhelmingly important consideration in example, the government has announced that government decisionmaking. On balance com- private investors will be invited to invest in petitive bidding is superior to negotiation, and widening two-lane toll-free roads into four-lane most developing countries have adopted this toll roads. The inclusion of the two-lane road, approach where possible. with its established trafÞc ßow, provides a larger and more certain return, making competitive Regulated tariffs with competitive bidding bidding possible. A third approach is to include other commercially proÞtable opportunities, In many situations tariffs are not determined by such as commercial development of real estate competitive bidding but are Þxed by a regulatory in areas opened up by a new road, as part of the or other authority. In such cases competition can project. This internalizes beneÞts generated by be used to select the private investor by soliciting the project, improving the attractiveness of the competitive bids in terms of the license fee investment and making competitive bidding offered during the concession period or in terms possible. A variant of this approach is to delink of a revenue-sharing arrangement. This approach the infrastructure component of the project from is particularly well suited to cases in which the the exploitation of associated proÞt-making independent producer deals directly with the opportunities and to solicit competitive bids for Þnal consumer and demand forecasts ensure each separately. Explicit subsidies can then be proÞtable operation. In telecommunications, for provided for the infrastructure component, example, there is often signiÞcant unsatisÞed Þnanced by revenues realized from the prof- demand at prevailing tariff levels, and new itable component. In Hong Kong, for example, licensees can expect to be proÞtable within a rel- the real estate development rights over each sta- atively short time.2 A similar situation may tion on the rail link between the city center and obtain in port development, where capacity may the new airport have been bid out competitively, be visibly overstrained and private sector and the revenues generated will be used to investors may be willing to expand port facilities Þnance the airport. Financing Private Sector Infrastructure 91

Public acceptance of tariffs reßect large subsidies, either explicit (through the budget) or more often hidden (in the form of Any of these methods of Þxing tariffs can ensure public sector losses). Consumers pay for these adequate returns to investors. More difÞcult is subsidies in the form of higher taxation or ensuring that the resulting tariffs pass the test of reduced levels of expenditure on schools, public public acceptance. Private sector suppliers will health, and other essential services, but this often require higher tariffs than those being implicit payment is usually not recognized as a charged in the public sector system, because pub- cost. Public acceptance of higher tariffs from pri- lic sector supplies of urban services, roads, and vate sector projects therefore depends crucially even power, are typically heavily underpriced, on public realization that continuation of subsi- reßecting large subsidies. The switch from under- dized public sector tariffs is simply not feasible. priced public sector services to fully pricedÑand This is indeed the case in most developing coun- therefore more expensiveÑprivate sector ser- tries, since the public sector cannot even ensure vices can generate resistance from consumers.3 continued supply, let alone provide increased Higher-priced services from the private sec- supply, at prevailing prices. Indeed, one of the tor may not be resisted if the private sector is compulsions for seeking private investment in seen as providing an additional, and perhaps infrastructure development is precisely the lack higher quality, source of supply, with consumers of public sector resources because of chronic retaining the choice to continue with the existing underpricing. lower-quality public sector service. Introduction This is not to say that tariff increases by pri- of a new privately operated toll highway as a vate sector providers should be uncritically higher-priced but faster alternative to a publicly accepted. One of the arguments in favor of maintained toll-free road may not evoke con- involving the private sector in infrastructure is sumer resistance, for example. However, con- that it is likely to be more efÞcient than the pub- version of toll-free road into a toll road could lic sector, and it is important to ensure that these meet with stiff resistance.4 The difference in con- efÞciency gains are achieved. The cost of ser- sumer reaction to private entry into telecommu- vices supplied by the private sector should nications and electricity generation in India therefore be the lowest possible and should com- illustrates the problem. Consumers showed no pare favorably with the real economic cost resistance to the entry of new private sector cel- (excluding subsidies) of the public sector alter- lular telephone service providers, which offered native. At Þrst glance cost minimization can be a higher-cost service that competed with the ensured by competitive bidding, but if compar- Þxed public sector phone service. In contrast, the ison with the public sector alternative is an entry of independent power producers selling important benchmark in ensuring public accep- power to the State Electricity Boards (SEBs), tance, competitive bidding is effective only if the which then distribute power to Þnal consumers, public sector also participates in the bidding. did meet with some resistance. Although the tar- The experience of Hyderabad, India, in privatiz- iff charged by independent power producers to ing the supply of drinking water is instructive in the SEBs does not directly affect the tariff this context. International bids were solicited for charged by the SEBs to Þnal consumers, there a $300 million urban water supply project, and was concern that reliance on higher-priced pri- three bids were received. However, the cost of vate sector power would raise the average cost the lowest bid was found to be more than 60 per- of the SEBs, which would eventually lead to cent higher than the estimated real cost (exclud- higher prices for consumers. ing subsidies) if the project were to be Is such consumer resistance justiÞed? The implemented by the public sector. The city answer clearly depends on whether the cheaper authorities decided to reject all bids and opt for public sector supply reßects greater efÞciency the public sector alternative. Cost efÞciency of compared with the private sector alternative or private sector infrastructure projects, including merely reßects its subsidization by the govern- comparison with the public sector alternative, ment. In most cases low public sector tariffs must be a prime consideration in evaluating 92 Choices for EfÞcient Private Infrastructure Provision in East Asia such projects. Construction risk. Construction risk refers to Risk mitigation and private Þnancing unexpected developments during the construction period that lead to time and cost over- All investment projects involve some risk, but runs or shortfalls in performance parameters of infrastructure projects in developing countries the completed project. High capital intensity are perceived as unusually vulnerable to risks, and a relatively long construction period make which constrains Þnancing. Risks are perceived project costs especially vulnerable to delays as high partly because projects are typically and cost overruns. As a result construction risk undertaken not by established utility companies is generally higher in sectors such as power and with strong balance sheets but by special pur- roads and lower in sectors such as telecommu- pose companies executing individual projects nications and urban services. on a build-operate-transfer (BOT) or build-own- Construction risk can be reduced through a operate (BOO) basis. Project Þnancing is on a variety of instruments. The reputation and nonrecourse basis (that is, lenders do not have experience of the sponsors and the engineer- recourse to the sponsor company but look solely ing, procurement, and construction (EPC) con- to the revenue stream of the project available to tractor is an important element in assessing meet debt service obligations). The risks associ- construction risk. Project sponsors can shift a ated with the revenue stream are therefore scru- portion of the construction risk to the EPC con- tinized. Equity investors may be willing to tractor through EPC contracts that provide for accept higher levels of risk in return for higher turnkey responsibility, with penalties for expected returns on their equity, but lenders typ- delays and shortfalls in performance parame- ically have a lower tolerance for risk and a ters of the plant on completion. Such perfor- greater need for risk mitigation mechanisms. mance guarantees add to the cost of the project. Although governments conduct project negoti- While construction risk can be shifted to some ations with the sponsors, it is the lenders behind extent, it cannot be eliminated entirely, since the scenes who set risk mitigation standards and penalties for nonperformance are typically determine whether projects are Þnanceable. capped at certain levels and the residual risk has to be borne by investors. However, lenders Unbundling different kinds of risks would be satisÞed with risk sharing that reduces project risk to a level that can be The general principles for risk mitigation are absorbed by equity investors without jeopar- well known. The various risks involved should dizing loan repayments. be unbundled and assigned to the participants able to manage them at least cost. Risks that can Operating risks. The technical performance be more efÞciently handled by agencies other of the project during its operational phase can than the project are shifted to these agencies, fall below the levels projected by investors for thereby reducing the residual risk borne by the a number of reasons. Operating risk is usually project. This process of shifting risks typically low for infrastructure projects that rely on a involves a cost, which is subsumed in the tariff tested technology, as is the case with most by the sponsors. If risks have been efÞciently power plants and roads. It is higher in sectors assigned to those best able to manage them, the in which the technology is untried or is chang- cost of risk management is minimized and the ing rapidly, such as telecommunications. tariff is a minimum-cost tariff. Operating risks are typically mitigated by The major risks involved, the methods for entrusting operation to experienced opera- handling these risks, and the problems that can tions and maintenance contractors. arise in each case are discussed in the following Contractual arrangements with such contrac- sections. Some of these risks are prevalent in tors can include some provisions for liquidated most investment projects. Many are particularly damages. Many risks during the operational important in infrastructure projects. phase, including certain force majeure risks, Financing Private Sector Infrastructure 93 are commercially insurable, and private pendent power producer sells power to a investors will typically insure against such risks. monopoly distributor or a water supply project One source of operating risk that is very sells water in bulk to a monopoly urban water important in the power sector is fuel supply risk. distributing company. In other cases, such as Power projects are highly vulnerable to inter- telecommunications, ports, and roads, where ruption of fuel supply, and independent power the private producer deals directly with indi- producers generally seek to shift this risk to the vidual users and users typically face competing fuel supplier or the purchaser. Private Þnancing options, market risk is borne by the investor. of power projects depends critically on the abil- Investors are expected to undertake market ity to negotiate satisfactory fuel supply agree- studies and satisfy themselves that market ments, with appropriate penalties payable by demand projections at feasible levels of tariffs the fuel supplier in the event of nonperfor- would yield adequate proÞtability. mance. Fuel supply problems are being tackled The situation in which no reasonable toll- in different ways in different private sector cum-trafÞc projection can ensure proÞtability power projects in India. The 700-megawatt must be distinguished from market risk, which Dabhol project in Maharashtra relies on refers to situations in which trafÞc is projected to imported naphtha, with the fuel supply risk be adequate but there is considerable uncer- borne largely by an international supplier. The tainty in the forecast. Financial projections must 235-megawatt gas-based GVK project in Andhra allow for downside possibilities. In these situa- Pradesh relies on natural gas supplied by the tions project sponsors may expect the govern- public sector monopoly supplier. In the event of ment to share downside risks through a fuel interruption, the supplier has the option of guarantees involving payments to cover part of switching to more expensive imported naphtha, the earnings forgone if trafÞc falls below a cer- with the higher fuel cost Òpassed throughÓ to the tain level. To ensure symmetry such guarantees tariff. In the 1,040-megawatt Visakhapatnam can be balanced by a corresponding sharing of coal-based power project in Andhra Pradesh, revenues if trafÞc exceeds a certain level. In this the fuel supplier, Coal India Ltd., is a govern- way part of the risk can be shifted to the gov- ment-owned company, and coal transportation ernment. Although governments are normally depends on Indian Railways, which is also gov- reluctant to offer such guarantees, they may well ernment owned. The fuel supply agreements represent the less expensive option if the only with Coal India Ltd. stipulate substantial liqui- alternative is for the entire burden of uncertainty dated damages, which cover the Þxed capital to be borne by the government. charges and expected returns upto certain levels, in the event of nonsupply. In the 1,000- Interest rate risks. Interest rate risks arise megawatt Bhadravati power project in because interest rates can vary during the life of Maharashtra, the private producer is develop- the project. They are particularly important in ing a private sector captive coal mine to supply infrastructure projects because of the high capi- coal to the project. The project sponsors are tak- tal intensity and long payback periods. High ing on the fuel risk because fuel is being sup- capital intensity implies that interest costs rep- plied by an associated company. resent a large part of total costs; long payback periods mean that Þnancing must be available Market risks. Market risks relate to the possi- over a long period, during which interest rates bility that market conditions assumed in deter- may change. One way of handling interest rate mining the viability of the project are not risk is to pass it on to consumers, as, for exam- realized. NonfulÞlment of demand projections ple, in arrangements in which the impact of is an obvious example of market risk. In certain interest rate variations on unit costs are treated situations investors expect the monopoly pur- as a Òpass throughÓ into the tariff. In the cost- chaser to guarantee a minimum level of pur- based tariff formula used in many power pro- chase, thus eliminating market risk for the jects in India, for example, interest costs are built investor. This is typically the case when an inde- into the tariff. Such an approach is neither nec- 94 Choices for EfÞcient Private Infrastructure Provision in East Asia essary nor desirable, however, since any ments cannot develop as long as foreign arrangement that automatically passes on thses exchange markets remain tightly regulated. costs to consumers reduces incentives for cost The absence of hedging instruments is not minimization. An alternative is to allow the risk the only problem. The inherent uncertainty to be borne by the investor, who in turn can about exchange rate movements in developing hedge the risk through devices such as interest countries is such that even if hedging instru- caps and collars. The feasibility of this option ments were to evolve they would be very expen- depends on the sophistication of the relevant sive. The only way to reduce foreign exchange Þnancial markets and the availability of hedging risk in this situation is to limit the extent of exter- instruments. Typically, it is much easier to hedge nal Þnancing. This in turn depends on the exis- interest rate risks in international markets than tence of a healthy domestic capital market in domestic markets, since domestic hedging capable of providing sufÞcient domestic Þnanc- instruments are not available in most developing for infrastructure projects. ing countries. The cost of hedging would, of course, have to be borne by the project and Payment risk. Investors in infrastructure also reßected in the tariff. face the risk of not being paid for services delivered. The importance of this risk varies across Foreign exchange risks. Two types of foreign sectors. It is not very important in projects in exchange risks need to be distinguished. One which the sponsor deals directly with a multi- relates to exchange convertibility, the assurance tude of consumers, as in the case of a telephone that revenues generated in domestic currency company, a toll road, or a port. It becomes very can be converted into foreign exchange for mak- important in situations in which an independent ing payments abroad. This risk must be borne by power producer has to supply electric power to the government through suitable convertibility a monopoly buyer, such as a public sector dis- guarantees. The other type of risk is exchange tributor, or a water purifying company has to rate risk, the risk that exchange rate changes lead supply water to a municipal distributor. Because to large increases in the domestic currency costs the Þnancial condition of public sector utilities of payments denominated in foreign currency. in developing countries is often very weak, This risk is extremely important for infrastruc- investors are naturally concerned about the risk ture projects that rely heavily on foreign Þnanc- of nonpayment for power or water delivered to ing but that have tariffs Þxed in domestic the distributor when the producer has no alter- currency. native outlet for the product. Exchange rate risk can be handled in differ- The long-term solution to this problem is to ent ways. When the tariff is Þxed in foreign cur- improve the Þnancial standing and creditwor- rency (as may be the case with port charges) or thiness of the utilities or to privatize distribution when it is automatically adjusted to reßect the so that private sector suppliers can deal directly impact of exchange rate variation on those cost with private distribution companies or under- components that are denominated in foreign take distribution themselves. Pending such exchange, exchange rate risk is borne by con- improvement a variety of alternatives exist. sumers. In many cases, however, tariffs may be Independent power producers in India have indexed only to domestic inßation, exposing the typically sought state government guarantees of project to the residual foreign exchange risk. It is payment for power delivered and credit not easy to shift foreign exchange risk in such enhancement through a counterguarantee of the cases. If long-term swaps between domestic and state governmentsÕ obligations by the central foreign currencies were readily available it government. Alternatively, they have sought to would be possible to hedge this risk at a cost. set up escrow arrangements under which pay- Such swaps are typically not available in most ments due to the utility company from high- developing countries, however, partly because quality industrial consumers are placed in of inadequate market development and partly escrow accounts for settlement of the dues of the because of government policy. Hedging instru- private power producers as a Þrst charge. Financing Private Sector Infrastructure 95

ment Guarantee Agency (MIGA), or bilateral Regulatory risk. Regulatory risk arises investment protection agreements. They can also because infrastructure projects have to interface be addressed by building into the project agree- with various regulatory authorities throughout ment appropriate levels of compensation for the life of the project, making them especially arbitrary action, subject to international arbitra- vulnerable to regulatory action. Tariff formulas tion. The World BankÕs new partial risk guaran- ensuring remunerative pricing at the start of the tee instrument, which covers debt service project can be negated by regulatory authorities payments in case they are interrupted because of on the grounds that the tariff was too high, as nonperformance of speciÞc government obliga- happened in the Bangkok Second Expressway tions, is another instrument that can play a use- and the recent privatization of the water supply ful role in this context. in Manila. Problems can arise from the environ- The risks enumerated above are not equally mental sensitivity of many infrastructure pro- important in all projects, the signiÞcance of par- jects. Extensive environmental clearances are ticular risks will differ from project to project, usually necessary at the start of the project, but depending upon sector characteristics. Road clearances can be challenged in public interest projects may have high construction risks, low litigation or through direct activism by non- operating risks, and high market risks. governmental organizations (NGOs), which can Telecommunication projects may have low con- lead to delays in construction or disruption in struction risks but high market risks. Power pro- operation. The experience of the Dabhol Power jects with suitable offtake guarantees may have Project in the Indian State of Maharashtra exem- high construction risks, relatively low opera- pliÞes this problem (see box 6.1). Another source tional and market risks, and high payment risk. of regulatory risk is that environmental concerns Each project has its own risk proÞle, and risk and standards can become more stringent dur- mitigation structures will vary depending on the ing the life of the project, adding to the costs of speciÞc circumstances of each project. operation. Private investors will expect explicit Because of the nature of the risks and the assurances that cost increases imposed because involvement of many participants, including of regulatory action will be reßected in a corre- project sponsors, lenders, government agencies, sponding adjustment in the tariff to project prof- and regulatory authorities, risk mitigation itability. arrangements are usually complex. They In general, regulatory risk is best handled by involve detailed legal and contractual agree- establishing strong and independent regulatory ments that specify the obligations of different authorities that operate with maximum trans- participants and set forth clear penalties for non- parency of procedures within a legal framework performance and protection to investors against that provides investors with credible recourse actions beyond their control. The complexity of against arbitrary action. This is not simply a mat- these arrangements often delays implementa- ter of setting up new systems and procedures. tion. Because public sector infrastructure pro- The systems must be perceived as credible, some- jects do not use such arrangements, host country thing that will happen only when sufÞcient expe- governments are often unfamiliar with them. rience is gained about their functioning. Until For example, public sector power generating then risk perception will remain signiÞcant. companies that purchase fuel from other public Political risk. Infrastructure projects have high sector companies typically do not insist on fuel visibility, and there is always a strong element of supply agreements with strict penalty clauses of public interest. This makes them vulnerable to the type demanded by the private sector. Nor do political action that can interrupt or upset settled they insist on power purchase agreements with commercial terms; in extreme cases it can even as much protection in terms of guaranteed com- lead to cancellation of licenses or nationalization. mitments to purchase power, incentive pay- These risks can be partially mitigated through ments, and penalties. More generally, public political risk insurance offered by multilateral sector interactions for contractual obligations organizations, such as the Multilateral Invest- are often loosely deÞned, with a great deal left to 96 Choices for EfÞcient Private Infrastructure Provision in East Asia trust rather than laid down in tightly deÞned, improved management of risk. legally binding contracts. Private sector In some situations, however, private sector investors cannot be expected to accept this projects face risks that do not arise in the case of approach. Moreover, a much higher level of due public sector projects. For example, private diligence is expected from government agencies investors may be concerned about risks stem- in dealing with the private sector. ming from lack of clarity of government policy, For all these reasons, the evolution of satis- the absence of a credible regulatory system, and factory risk mitigation arrangements is difÞcult the possibility of arbitrary political action. High and time consuming. Lack of experience with risk perception on these counts leads to high pri- such arrangementsÑand inadequate apprecia- vate sector project costs, because many investors tion of their necessity on the part of host gov- are discouraged from exploring investment pos- ernmentsÑcan lead to delays that hold back sibilities, leaving the Þeld to investors willing to project implementation. These problems are live with greater uncertainty in the expectation more severe in the early stages and are illus- of higher returns. These high returns are ulti- trated by IndiaÕs experience in trying to attract mately paid for by the consumer in the form of private sector investment in power generation higher tariffs (or where tariffs are Þxed inde- (box 6.1) and telecommunications (box 6.2). pendently, lower license fees accruing to the exchequer). It should be noted, however, that Costs of risk mitigation higher costs in these situations are not caused by risk mitigation but arise precisely because risks Risk mitigation involves costs, which raises the cannot be mitigated and are traded off against question of whether private sector projects, high returns. The aim of policy in such situations which require risk mitigation, are unnecessarily should be to reduce perceived risks by intro- costly compared with public sector projects. The ducing greater clarity in government policy and answer depends on whether the risks involved providing an environment that reassures represent real potential costs that have to be investors. Such an environment, which should borne even if the project is undertaken by the include a legal framework for enforcing con- public sector and whether the premium paid for tractual agreements and independent regula- risk mitigation is too high. tory authorities to ensure fair treatment, would Many of the risks that concern private sector encourage a larger number of private investors investors represent contingencies that should to enter the Þeld. The resulting increase in com- concern public sector projects as well. For exam- petition could be expected to reduce the cost at ple, the risk of a fuel supply interruption is just which services are offered. as great in a public sector project, and the resulting loss of power generation represents a real Sources and methods of Þnancing cost to the project and the economy. Public sector power producers are less concerned with Once suitable tariff Þxing mechanisms and risk protecting themselves against these risks, partly mitigation structures are in place, private sector because they are less concerned with ensuring projects become Þnanceable in principle. At this the commercial proÞtability of each project and stage project implementation depends on the partly because they perceive that shifting these ability to develop a Þnancing package with a risks to other parts of the public sector would not mix of Þnance suitable for the project. This mix improve the system as a whole.5 Risk mitigation varies from sector to sector. Telecommunications in these cases raises the explicit cost of private projects, which face relatively high market risks, sector projects, but it does not necessarily make may require a relatively low debt component, them more costly for the economy as a whole with debt to equity ratios close to 1:1. Power pro- since the same costs are incurred in public sector jects with assured power purchase arrange- projects, whether or not they are made explicit. ments may be Þnanceable with debt to equity Explicit assignment of risk to agents better able ratios of 2.5:1 or even 3:1. The maturity require- to manage them could reduce costs if it leads to ments of debt will also vary across sectors. Financing Private Sector Infrastructure 97

Box 6.2 Competitive bidding in telecommunications services in India India’s telephone services were run as a public sector monop- purposes of computing taxable income, the oly until 1992, when private sector cellular services were Department of Revenue took the view that under allowed to operate in four metropolitan cities (Delhi, Bombay, Indian Tax Law it would have to be treated as a cap- Calcutta, and Madras). Shortly thereafter both cellular and basic ital expenditure. It has subsequently been clarified services were opened up for private sector operators in twenty that the license fee will be treated as a capital expen- telecommunications circles covering the entire country. diture, with full amortization within the license Although at each stage private sector operators were chosen period. through a form of competitive bidding, the process was criti- • Winning bidders ran into difficulties in reaching finan- cized and challenged in court. cial closure, because it was not clear whether the Introduction of cellular services in the four cities was done licenses could be assigned to lenders in the event of by soliciting bids from companies shortlisted on the basis of a debt service default. Lenders took the view that qualifying criteria. Call charges were independently fixed, and without assignability the projects could not be potential entrants were asked to bid in terms of criteria such as financed. It was subsequently agreed that these the rental charge on the phone, the extent of domestic equip- licenses could be assigned. ment purchase, and projections of investment and perfor- • Disputes arose over the interconnection charges mance. The weights assigned to each criterion for bid levied on the new operators for connecting with the evaluation were not made public. The initial selection of existing public sector system. The tender documents licenses on this basis was challenged in court, and a fresh selec- had not specified the interconnection charges, indi- tion had to be made at the direction of the court. cating only that they would be based on costs. In the The bidding process was much more transparent for the event, private operators claimed that the charges extension of cellular and fixed phone services throughout the were much higher than justified, and the charges rest of the country. Eligibility criteria were made public, and bids were subsequently reduced through consultation. were solicited for individual circles on the basis of the license • The absence of a telecommunications regulatory fee offered and three other quantifiable criteria. Weights authority meant that negotiations on points of dispute assigned to each criterion were also made public. Potential bid- were conducted between new private operators and ders were even asked to seek clarifications, and all clarifications the Department of Telecommunications, which is issued were made public before the final submission of bids. also responsible for operating the public sector tele- Despite these efforts at transparency, problems persisted: phone system. This led to complaints from private • Although bidders were given the opportunity to seek sector operators of lack of transparency and fairness. clarifications, key issues remained unclear. For exam- A statutory regulatory authority has since been estab- ple, although bidders had assumed that the license lished. fee would be treated as a current expenditure for

Power and roads, which have longer payoff Private sector infrastructure projects require periods, typically require long maturities, while substantial equity Þnancing, with higher equity telecommunications projects can manage with requirements required for projects with higher shorter maturities. The mix between domestic levels of perceived risk. Project sponsors are an and external Þnancing also requires careful con- important source of equity, but they contribute sideration. Even if external Þnancing is available only part of the total equity in most cases. for well-managed developing countries, foreign Although preconstruction, or developmental, exchange risk management considerations may costs represent only a small fraction of total cost argue in favor of keeping the amount of foreign in infrastructure projects they can nevertheless Þnancing within reasonable limits. run into several millions of dollars, all of which There are limitations and constraints associ- must be Þnanced by equity provided by project ated with each source of debt and equity Þnanc- sponsors.6 Once the developmental phase ends ing (table 6.1), which should be kept in mind equity must be committed as part of the Þnanc- when devising Þnancing packages for individ- ing package. Sponsors typically commit a sub- ual projects. stantial proportion of total equity themselves, and they also tie up additional equity from other Equity Þnancing investors at this stage. Foreign sponsors may often be keen to link up with domestic investors 98 Choices for EfÞcient Private Infrastructure Provision in East Asia at this stage on the grounds that this will reduce ture projects until there is a track record of per- political risk. Domestic investors tend to evalu- formance. However, once project implementa- ate risk less conservatively than foreign tion proceeds and revenues begin to be investors, and their involvement often helps to generated through partial commissioning, it improve the perceptions of foreign investors. may be possible to tap a wider range of equity Well-structured projects can expect to mobi- investors. This can be a useful Þnancing strategy lize equity from international infrastructure in the case of power projects with more than one funds specializing in investment in infrastruc- generating unit or in telecommunications pro- ture projects. The Global Power Fund, which has jects, where the build up of line capacity occurs a target of $1 billion, is an example of an infra- over time. structure fund aimed at Þnancing power projects in emerging markets. The AIG Asian External debt Þnancing Infrastructure Fund, which will invest $1 billion in the Asia-PaciÞc region, and the $750 million Several sources of external debt Þnancing are Asian Infrastructure Fund are examples of available to well-structured private sector pro- regional funds. The amounts available through jects in countries with reasonable credit ratings. these funds remain modest relative to the total requirement, but the pool of global capital they Export credit agencies. Export Credit Agencies can tap is very large, and the ßow of equity from (ECAs), which provide direct Þnance and guar- this source could increase substantially if bank- antee commercial bank credit, have been the able projects become available and the track dominant source of international capital to record of implementation improves. An impor- Þnance infrastructure projects. In recent years tant aspect of these funds is that they allow inter- ECAs have tended to guarantee bank loans. national investors to pool risks by investing in a Traditionally, they funded public sector projects mix of projects. They also enable institutional backed by sovereign guarantees, with some investors, who are relatively risk averse, to willingness in recent years to lend against guar- invest in infrastructure projects after the con- antees of commercial banks. Unless ECAs can struction stage, when project risks are much reorient themselves to provide Þnancing with- lower. This provides valuable opportunities for out sovereign guarantees, their role in Þnancing Òtake-outÓ Þnancing, enabling projects to be private sector infrastructure projects is likely to Þnanced through the earlier and riskier stage by be limited. much larger involvement of equity from the sponsors or by high-cost debt, with a subsequent International commercial banks. International restructuring through attraction of equity from commercial banks are the largest source of pri- infrastructure funds through sale of sponsorsÕ vate Þnance for infrastructure development in equity or reÞnancing of debt with equity. developing countries. Of the $22.3 billion raised A limited amount of equity support for pri- by developing countries for infrastructure vate sector infrastructure is also available from Þnancing in 1995, syndicated loans accounted multilateral organizations, such as the for $13.5 billion, bonds for $5.3 billion, and International Finance Corporation and the pri- equity for about $3.5 billion (International Bank vate sector window of the Asian Development for Reconstruction and Development 1997). Bank. Although these funds can provide only a Banks tend to be Òhands onÓ Þnanciers, lending small amount of capital, their participation in a on the basis of a detailed analysis of project risk. project provides comfort to other investors. There are important limits to bank Þnancing, The scope for raising equity from domestic however. The number of international banks capital markets is probably limited. Public utili- actively involved in developing countries is lim- ties and domestic institutional investors may be ited, and they are subject to exposure limits for willing to contribute part of the equity for project projects and countries. This often leads to syn- expansion, but signiÞcant domestic equity sup- dication, which involves cumbersome proce- port may not be forthcoming for new infrastruc- dures. Another important limitation of Financing Private Sector Infrastructure 99

Table 6.1 Financing sources for private sector infrastructure Domestic sources External sources Equity Domestic developers (independently or in collaboration with International developers (independently or in collaboration with international developers) domestic developers) Public utilities (taking minority holdings) Equipment suppliers (in collaboration with domestic or international Other institutional investors (likely to be very limited) developers) Dedicated infrastructure funds Other international equity investors Multilateral agencies (International Finance Corporation, Asian Development Bank)

Debt Domestic commercial banks (3-5 years) International commercial banks (7-10 years) Domestic term lending institutions (7-10 years) Export credit agencies (7-10 years) Domestic bond markets (7-10 years) International bond markets (10-30 years) Specialized infrastructure ﬁnancing institutions Multilateral agencies (15-20 years) Bilateral aid agencies commercial bank lending is the mismatch ing to Generally Accepted Accounting Practices between the Þfteen- to twenty-year loans (GAAP). However, this window can be effec- needed by infrastructure projects and the seven- tively tapped only by corporate bodies with rel- to ten-year maturities sought by international atively high credit ratings. Newly established banks. Maturities of commercial bank loans can infrastructure companies may Þnd it difÞcult to be lengthened ab initio through multilateral access bond markets. Despite these limitations guarantee support for later period repayments, bond markets are likely to become increasingly as discussed later in this section. Reliance on important over time as more and more private bank Þnancing for infrastructure projects must sector infrastructure projects are successfully therefore be part of a mix involving other long- implemented in developing countries, compa- term lending, or it must be accompanied by suit- nies engaged in such projects gain Þnancial able reÞnancing arrangements. recognition, and countries develop track records of successful implementation. Even new infra- International bond markets. Bond Þnancing is structure companies may be able to access bond in many ways the ideal source of Þnance for markets in the postconstruction stage, when risk infrastructure. Costs are higher than for syndi- perceptions have diminished and projects begin cated loans, but maturities of ten to thirty years to generate steady revenue streams. Bond are typical, and even longer maturities are avail- Þnancing could be used in this way to reÞnance able for creditworthy issuers. Bond Þnancing shorter-term loans taken initially to Þnance the has been the fastest growing source of Þnance construction stage. for developing countries in recent years, with The pricing of private corporate securities total ßows increasing from $2.3 billion in 1993 to issued in international bond markets depends $45.8 billion in 1996 (International Bank for partly on corporate Þnancial characteristics and Reconstruction and Development 1997). Its role partly on country characteristics. The efÞciency remains modest, however, with only $5.3 billion of bond pricing can be enhanced by the existence provided in 1995 compared with $13.5 billion of sovereign debt actively traded in the market. from syndicated loans. This increases country visibility, and therefore One reason for the modest scale of bond the appetite for corporate securities, and also Þnancing of infrastructure is that access to inter- provides a benchmark against which corporate national bond markets is not easy. Rule 144A debt can be efÞciently priced. Issuing sovereign and Regulation S of the U.S. Securities and debt, however, implies that countries must be Exchange Commission allows non-U.S. compa- willing to accept continuous scrutiny of macro- nies to raise capital in the United States from economic performance and economic policies qualiÞed institutional buyers without comply- by international credit rating agencies. ing with the full listing procedures or conform- 100 Choices for EfÞcient Private Infrastructure Provision in East Asia

Multilateral institutions. Multilateral institu- access to commercial loans of only about six- tions, such as the World Bank and the Asian year maturities at the time, the partial credit Development Bank, which have traditionally guarantee helped to extend even the uncovered funded public sector infrastructure projects, are period of commercial lending beyond the nor- now willing to support private sector projects. mal six-year period to ten years, after which the The role of these agencies is necessarily limited, guarantee period extended it further to Þfteen however. There are many competing claims on years. In the Philippines the partial credit guar- their scarce resources, and diversion of antee has been used to support a $100 million resources to fund private sector projects may ten-year bond issue by the National Power represent no net gain for the economy. It can be Corporation in the form of a put option that argued, however, that these agencies can play an enables the investors to present the bonds to the important catalytic role in the early stages of World Bank for principal repayment at maturity. attracting the private sector into infrastructure. The Asian Development Bank has also provided The transparency of their project evaluation pro- loan guarantees. cedures and their ability to benchmark an individual private sector project in a particular Bilateral aid agencies. Bilateral aid agencies country against international experience of sim- have traditionally funded public sector infra- ilar projects could help avoid controversies that structure projects, but their role in funding pri- may otherwise arise about private sector pro- vate sector projects is likely to be very limited. jects. Their active involvement as lenders in a Their resources are severely limited, and their project can also help reduce risk perception on priorities are shifting to social sector projects, the part of other investors. However, the proce- making them reluctant to Þnance projects that dures of these institutions are often too cumber- are commercially Þnanceable. However, like some to be acceptable to private sector investors. multilateral agencies, bilateral agencies could The International Finance Corporation (IFC), play an important catalytic role in the early the private sector arm of the World Bank Group, stages of promoting private sector investment in could play an important role in Þnancing private infrastructure, especially by coÞnancing private sector infrastructure, but its scale of operations sector projects with multilateral agencies. is relatively modest. IFCÕs own commitments for infrastructure projects have increased from a lit- Domestic debt Þnancing tle less than $200 million in 1990 to $727 million in 1996, and IFC syndication provided an addi- Unlike the supply of external debt, which is tional $700 million in 1996. An important feature plentiful, the supply of domestic debt is severely of IFC syndication in Þnancing private sector limited in most developing countries. Analysis infrastructure is that it has brought in nonbank of 140 private sector infrastructure projects from Þnancial institutions, including international IFCÕs portfolio shows that only a sixth of debt insurance companies, to Þnance infrastructure Þnancing (which represented 61 percent of total projects in developing countries. A strong case project cost) was domestic debt (International can be made for much more extensive IFC Finance Corporation 1996). Moreover, all of the involvement in Þnancing private sector infra- domestic debt was from local commercial banks, structure projects in developing countries. which do not provide long-term Þnance. This is An innovative role played by multilateral clearly not a viable Þnancing pattern. If private institutions is the use of their guaranteeing sector investment in infrastructure is to increase capacity to extend the maturities of commercial substantially, more domestic debt must be loans to private sector infrastructure projects. secured, and the composition of this debt must The World BankÕs partial credit guarantee is an shift to longer maturities. This can happen only example of such assistance. It was used to guar- if domestic debt markets in developing coun- antee principal repayment from year 11 to year tries develop. 15 for a $150 million commercial bank loan for the Zhejiang project in China. Since China had Development of domestic debt markets Financing Private Sector Infrastructure 101

Domestic debt markets in developing countries Statutory pre-emption of resources is high in are underdeveloped for many reasons, and many countries. In India insurance is also a pub- action to develop these markets has to be taken lic sector monopoly, although the government on several fronts. A high rate of domestic sav- has recognized that reform of the insurance sec- ings is the most important structural prerequi- tor is linked to Þnancing of infrastructure and site for ensuring an adequate ßow of domestic has initiated a process of reform in this sector. An Þnance for private infrastructure. High savings ideal environment for domestic debt markets is rates are not enough, however. Most East Asian one in which domestic savings rates are high, Þs- economies, for example, have very high rates of cal deÞcits are low, and there is a strong insur- savings, and yet debt markets in these ance-pension fund segment in the Þnancial economies are underdeveloped, with long-term sector. debt particularly scarce. A critical requirement for well-functioning Tax incentives for infrastructure Þnancing. debt markets is a sound macroeconomic bal- Faced with weak debt markets many develop- ance, as reßected in modest Þscal deÞcits. High ing countries have sought to use tax incentives Þscal deÞcits have signiÞcant negative effects. If to stimulate a larger ßow of domestic savings to monetized they lead to inßation, which discour- infrastructure development. A wide variety of ages savings in general and long-term saving in incentives are in use in many countries: particular. If not monetized they put pressure on ¥ The most popular incentive, available in interest rates, which discourages investment, China, India, and Thailand, is a tax holiday especially in projects with long gestation peri- for the proÞts of private sector infrastructure ods, such as infrastructure. High interest rates projects. This instrument is not aimed specif- also tempt governments to intervene in Þnancial ically at domestic debt Þnancing. However, it markets to reduce the cost of government bor- improves project proÞtability and thus rowing by forcing banks, insurance companies, enables the project to compete more effec- provident funds, and pension funds to invest a tively with other claimants for scarce domes- high proportion of their assets in government tic debt. The additional cash ßow also securities. This reduces the cost of government enables the project to sustain larger debt ser- borrowing, but it obviously does not eliminate vice payments, thus enabling it to manage the crowding out effect of high levels of govern- with shorter maturities, an important advan- ment borrowing for nongovernment borrowers. tage where long-term debt is scarce. In fact, the artiÞcial lowering of interest rates on ¥ Incentives can also be directed at individual government securities distorts the government holders of equity or debt. In India, for exam- debt market, discouraging active trading in gov- ple, long-term savings by individuals in the ernment securities and preventing the emer- form of premia for life insurance policies or gence of a reliable yield curve, all of which work contributions to the Provident Fund beneÞt against the development of an efÞcient debt from a tax credit. This incentive has been market. Effective control over Þscal deÞcits is extended to investments in the shares or therefore an important element in any strategy bonds of infrastructure projects. In a similar for developing debt markets. vein, capital gains on sale of shares have been Another factor that helps to develop deep exempted from taxation if the proceeds are and liquid domestic debt markets is the exis- invested in equity or debt instruments issued tence of strong long-term contractual savings by infrastructure projects. These incentives institutions, such as insurance companies and do not distinguish between equity and debt, pension funds. These institutions have long- but they will help to attract debt Þnancing term liabilities and therefore have a natural into infrastructure. interest in long-term debt instruments of high ¥ Tax incentives can also be aimed at Þnancial quality. Unfortunately, the insurance and pen- intermediaries. Financial institutions in India sion funds sector is in only an early stage of are encouraged to provide long-term Þnance development in most developing countries. for infrastructure by allowing 40 percent of 102 Choices for EfÞcient Private Infrastructure Provision in East Asia

the proÞt attributable to such loans to be nine debt is also reßected in the emergence of deducted from income in computing taxable dedicated mezzanine debt funds, such as the income. Asian Infrastructure Mezzanine Capital Fund, Tax incentives are criticized by purists on the sponsored by the Prudential Capital Insurance grounds that they are indirect subsidies, which Company. The ability to adopt a mixed strategy are usually not justiÞable. But a good case can be of relying on a combination of higher-cost mez- made for such incentives, at least in the early zanine debt and lower-cost senior debt widens stages of attracting private investment. The con- the pool of investors that can be tapped and can cern that tax incentives may lead to excessively lower the overall Þnancing cost of the project high rates of return is fully met by ensuring a process of competition in Þxing tariffs or license The role of specialized Þnancial institutions. fees. Within such a framework tax incentives Many countries have sought to address deÞ- essentially allow private investors to provide ciencies in their domestic debt markets by creat- services at lower cost to the consumer than ing specialized institutions to deal with would otherwise be possible. Since public sector infrastructure Þnancing. Examples of such insti- suppliers beneÞt from various hidden subsidies tutions are the Pakistan Private Sector Energy (such as low-cost loans from the budget or pro- Development Fund, established in 1988, which vision of government equity on which a com- provides subordinated loans to private sector mercial rate of return is rarely earned or even power projects, and the Jamaica Private Sector planned for), the tax incentive serves only to Energy Fund, established in 1992, which was set level the playing Þeld. up to provide long-term Þnance. In India the Infrastructure Development Finance Company Innovative instruments with which to promote was recently set up as a private company, in debt Þnancing. Innovative Þnancing instruments, which the government has a minority stake, such as the use of mezzanine debt, can some- with the objective of playing a catalytic role in times attract domestic Þnancing to infrastruc- channeling resources into commercially viable ture projects. Mezzanine debt refers to hybrid infrastructure projects (see box 6.3). A similar instruments that are somewhere between debt institution is being set up in Colombia. and equity (subordinated to secured debt but Skepticism is sometimes expressed about senior to equity in the hierarchy of creditors). A whether creation of a specialized institution will variety of such instruments, including simple improve Þnancial intermediation. A new insti- subordinated debt, convertible debt, debt with tution adds little if it only redirects resources stock warrants, and debt with an additional that would have ßowed from existing institu- interest payment above the coupon rate contin- tions to target sectors. Specialized institutions gent upon Þnancial performance, exists. These may appear to contribute additional resource instruments appeal to investors looking for ßows if they are a conduit for government higher returns than secured debt provides or for resources earmarked to support private sector a share in the Òup sideÓ risk of the project. infrastructure or if they are able to use govern- Introduction of mezzanine debt in project ment guarantees to obtain funds from the mar- Þnancing for a given level of equity helps to ket at lower rates. However, the same subsidies improve the quality of senior debt and therefore could be extended just as effectively by channel- its marketability. ing this support through existing Þnancial insti- There are several examples of the use of mez- tutions. It can be argued that because of their zanine debt in infrastructure Þnancing in Asia. special mandate specialized institutions will The Zhuhai Highway Company Ltd. raised $200 ensure a larger ßow of funds to target sectors. If million in international capital markets, consist- more Þnancing ßows to target sectors because ing of $85 million in senior notes and $115 mil- these institutions are better able to Þnd bankable lion in subordinated notes. The Manila Skyway infrastructure projects, then these institutions project relied on a combination of senior debt are providing valuable Þnancial intermediation. and mezzanine capital. The demand for mezza- If, however, more funds ßow to target sectors Financing Private Sector Infrastructure 103

Box 6.3 India’s infrastructure development finance company The Infrastructure Development Finance Company (IDFC) IDFC will provide direct lending, purchase of loans, and was incorporated in January 1997, with 40 percent of the cofinancing; take-out financing, standby finance, and refinanc- equity held by the government of India and the Indian Reserve ing of longer maturities; partial credit guarantees and other Bank and 60 percent held by nongovernment domestic finan- forms of credit enhancement for infrastructure projects; secu- cial institutions, foreign investors, and multilateral agencies. ritization of infrastructure loans and market making for these IDFC will operate on a commercial basis to finance viable pro- loans; and mezzanine finance. jects in power, telecommunications, roads, ports, and urban The initial capitalization, including Tier-II capital, is $530 services. It will not compete with existing financial institutions million. IDFC’s capitalization and commercial practices will as a direct lender but will engage in innovative financing to sup- enable it to achieve a high credit rating. It will also be able to port other institutions raise funds for infrastructure or provide benefit from credit enhancement through credit risk guarantees support for infrastructure projects in critical areas. provided by multilateral development banks. because these institutions simply apply lower raised will be reimbursed to the project. A standards of credit appraisal in order to achieve commercial fee should, of course, be charged some externally set target, the institutions may for this service. end up Þnancing infrastructure projects that ¥ Liquidity support: Bond issuance by infra- other Þnancial institutions regard as unÞnance- structure projects can be encouraged by pro- able on conventional criteria, and they will not viding liquidity support for such bonds in be contributing to the efÞciency of the Þnancial the form of a put option prior to maturity or markets. in the form of market making. The case for establishing a new institution ¥ Securitization: A specialized Þnancing insti- therefore depends on whether it Þlls some criti- tution could securitize the cash ßow from cal gap in the Þnancial environment facing infra- loans in a pool of successfully operating structure projects. Several such gaps justify infrastructure projects, thus helping to create creating a specialized Þnancing institution: a wider market for such assets. Pooling of ¥ Identifying Þnanceable projects: Specialized assets would help reduce risk through diver- Þnancing institutions may be able to identify siÞcation and thus create a high-quality asset Þnanceable infrastructure projects more that could be effectively marketed to both effectively and proactively than multipur- domestic and international institutional pose Þnancing institutions. Moreover, they investors. may be able to help structure projects in a ¥ Direct Þnancing: Conventional direct Þnancing manner that makes them Þnanceable, taking of infrastructure projects on a limited scale by a care to meet the complex risk mitigation specialized institution may give conÞdence to requirements of different types of investors. other investors, which could leverage larger ¥ Take-out Þnancing: Infrastructure projects ßows from other sources. This is especially true if may need Þnancing arrangements in which the institution aims to Þll critical Þnancing gaps. the project can be Þnanced initially on the The provision of subordinated loans, for exam- basis of shorter-term debt (such as credit ple, helps to improve the quality of senior debt from suppliers to Þnance equipment pur- and may stimulate a larger ßow of total resources chase) that is reÞnanced later by longer-term at lower cost than would otherwise be possible. debt. A specialized institution could help A specialized institution can also play a very guarantee such reÞnancing within a prede- useful role as an interface between the govern- termined Þnancing cost. This amounts to giv- ment and new private investors in infrastruc- ing the project an assurance that if ture. Many practical problems are likely to arise reÞnancing is not available on speciÞed in the course of implementing private sector terms when needed, it will either be pro- projects that may require constant review and vided directly by the institution or the differ- modiÞcation of announced policies and also of ence between the predetermined cost of the regulatory framework. A specialized Þnanc- Þnancing and the cost at which funds can be ing institution with direct involvement in indi- 104 Choices for EfÞcient Private Infrastructure Provision in East Asia vidual projects and with knowledge of domestic fact, it may take several years after a credible and international Þnancial markets can help to restructuring process has been initiated before identify problems and work cooperatively with these organizations gain full Þnancial credibility government agencies to Þnd solutions consis- in Þnancial markets. During this period the tent with the requirements of Þnanceability on guarantees of these organizations may not be the one hand and public concerns on the other. acceptable, and government guarantees may have to be provided as an interim arrangement. The role of government guarantees Extension of government guarantees in these circumstances can be justiÞed, provided the pro- A general issue that arises in the context of jects meet high standards of viability and the Þnancing private sector infrastructure projects is more fundamental corrective steps are under- the role to be played by government guarantees. way. In order to minimize the extent of guaran- Private investors seek guarantees to cover a vari- tee exposure, the guarantees can be structured to ety of circumstances. However, indiscriminate include Òfall awayÓ provisions, which are trig- use of the governmentÕs guarantee power is not gered as soon as certain credit benchmarks are justiÞable, since it involves a potential cost to the achieved (Johnson, Mody, and Shanks 1996). exchequer that becomes a real cost if the guarantee is invoked. Many projects that face Þnanc- Conclusions ing problems are denied Þnance because of genuine deÞciencies in Þnancial viability. In Despite active pursuit of private investment in such cases, the deÞciencies must be remedied at infrastructure by most developing countries and the source rather than being covered by govern- a growing number of success stories, the pace of ment guarantees. such investment remains slower than initially In some situations, however, extension of expected. The main reason is that the precondi- government guarantees is necessary and appro- tions for private Þnancing of infrastructure are priate. The most logical use of government guar- more difÞcult to establish than is commonly antees is to cover events over which the realized. Inadequate preparatory work leads to government has full control, such as national- unanticipated problems and delays in imple- ization, government action that forces interrup- mentating private sector infrastructure projects. tion of the project, or nonperformance of speciÞc One set of problems arises because infra- government obligations. In all these cases exten- structure sectors are invariably subject to tariff sion of government guarantees reduces the per- regulation and it is difÞcult to strike a balance ception of risk and therefore costs. Government between ensuring that tariffs are sufÞciently guarantees may also be sought to backstop remunerative to private investors and ensuring obligations of government-controlled entities that they are seen as fair to consumers. where the guarantees of these entities are not Consumer acceptance is especially a problem commercially acceptable. For example, private where consumers have grown accustomed to power producers selling power to public utili- unrealistically low tariffs charged by public sec- ties may insist on guarantees from the govern- tor systems, reßecting large explicit or implicit ment to cover nonpayment for power, or they subsidies. Since similar subsidies cannot be may expect the government to backstop guar- extended to the private sectorÑindeed, their antees of public sector fuel suppliers against continuation even for the public sector may not defaults in fuel supply agreements. In both cases be feasibleÑa shift to more viable tariffs is government guarantees are insisted on because unavoidable. Unless the need for this shift is of the lack of Þnancial credibility of the buying widely accepted, it will be difÞcult to attract pri- and supplying organizations directly involved. vate investment in infrastructure. The ideal solution in such cases is to improve the Even where the need for higher tariffs is Þnancial viability of these organizations so that accepted in principle, tariffs charged by private their own guarantees can be credible. This trans- sector suppliers may still attract criticism if they formation is bound to take time, however. In are perceived as too high. Economic efÞciency Financing Private Sector Infrastructure 105 requires that private sector projects should rep- take-out Þnancing. resent least-cost options. This objective is difÞ- Availability of domestic Þnance is perhaps cult to realize. Cost-based formulas for the most serious constraint on infrastructure determining tariffs make it difÞcult to ensure Þnancing. Infrastructure projects cannot be that efÞciency considerations have been fully Þnanced exclusively or even primarily through observed: the padding of costs is difÞcult to external capital, if only because tariffs are usu- detect and leads to unduly high tariffs and ally Þxed in domestic currency and a large share inßated rates of return. Competitive bidding of foreign currency Þnancing implies a corre- projects is the only transparent method of spondingly high foreign exchange risk. A sub- resolving this problem. It must be recognized, stantial share of project costs must therefore be however, that the effectiveness of competitive domestically Þnanced. Domestic debt Þnancing bidding depends critically on the quality of the is likely to pose a special problem because most bidding process. developing countries do not have well-devel- Risks associated with infrastructure projects oped domestic debt markets and long term debt also pose special problems in implementation. is especially scarce. Measures to develop domes- Many of the risks are common to any commer- tic debt markets are therefore crucial to support cial venture and can be handled in proven ways. private sector infrastructure projects. But other risks are unique to infrastructure, for By contrast, external capital is more plentiful example, those arising from interface with regu- for well-structured projects in countries per- latory authorities and with other government- ceived as investor-friendly and creditworthyÑ dominated agencies. These risks can be reduced both restrictive criteria, but applicable to a large to acceptable levels through explicit risk sharing number of countries. The pool of international arrangements that deÞne compliance obliga- debt and equity captial available for such pro- tions of the government and government agen- jects is fairly large and could grow substantially cies and specify penalties for default. But these as private sector projects are seen to operate suc- arrangements are complex and are very differ- cessfully in more and more countries. As with ent from the normal ones with public sector sup- domestic Þnance, the biggest problem is access- pliers. Governments are sometimes reluctant to ing long-term debt. International bond markets enter into these arrangements and often do not are the logical source for such capital, but access appreciate the need for them from the investorÕs to these markets remains limited, especially for point of view. new companies implementing projects on a non- Independent regulatory authorities with a recourse basis. Credit enhancement through clear mandate to ensure fair treatment for pri- partial credit risk guarantees of the type now vate sector suppliers help to reduce perceptions being offered by multilateral development of risk, as does an efÞcient legal system that pro- banks may be helpful in improving access to vides quick redress, especially in matters relat- bond markets. ing to contract enforcement. Few countries have The development of domestic debt markets all these institutions in place, however, and deÞ- requires an environment of Þscal prudence with ciencies in this area explain some of the delay in moderate Þscal deÞcits that do not put pressure project implementation. on domestic interest rates. It also requires the Financial markets also impose constraints on development of an efÞcient and liquid market project implementation. Once remunerative tar- for government debt, which provides the foun- iff structures and acceptable risk mitigation dation for developing a broader market for cor- arrangements are in place, projects have to porate debt. And it requires the development of achieve Þnancial closure. This requires mobiliz- institutions engaged in mobilizing long-term ing an appropriate mix of Þnancing in terms of savings, especially insurance and pension equity and debt. Infrastructure projects require funds, which have a natural appetite for high- long debt maturities, reßecting the long payback quality long-term debt. period. In the absence of long-term debt, they No country presents an ideal combination of need reasonable assurance of reÞnancing or circumstances and experience shows that there 106 Choices for EfÞcient Private Infrastructure Provision in East Asia

3. In principle it is possible for fully priced private sec- are many ways of solving problems that con- tor supply of services to be cheaper than underpriced strain such investmentÑways that differ from public sector services because of greater operational project to project and country to country. efÞciency. This effect may not offset the effect of hidden Financial markets show great scope for innova- subsidies in all cases, however. tion in tailoring Þnancing solutions to Þnancing 4. The Don Muang Tollway in Thailand has suffered needs. Policies need to be ßexible to allow such from inadequate traffic because the government did not dismantle the untolled flyovers, which were to innovation to ßourish. have been torn down as part of the concession agree- The problems discussed here appear formi- ment. Consumer preference for continuing with the dable, and indeed they are. But the upside is that toll-free option proved stronger than expected, because despite these problems an increasing number of the charging segment was not perceived as generating private sector projects are being implemented in beneÞts commensurate with costs. 5. The view that shifting risks from one part of the pub- an ever-growing number of countries. Greater lic sector to another serves no purpose is erroneous. clarity in policy and proactive efforts by gov- Even within a public sector framework, clear assign- ernments to create the conditions necessary to ment of risk to individual public sector entities, with attract private investment in infrastructure will incentives for risk management, would increase the result in successful implementation of more and effort made by individual entities to avoid the contin- more projects. This favorable experience will gency involved. For example, a fuel supply agreement between a public sector supplier of fuel and a public improve expectations among investors and sector producer of power with penalties for nonperfor- reduce perceptions of risk. That should help to mance is likely to create incentives for the fuel supplier accelerate a process that is clearly already under that will reduce disruptions in fuel supply. way, though still lacking the momentum that is 6. Risk is also highest at this stage, since there is no cer- needed and that is also feasible. tainty that a satisfactorily negotiated project will emerge. Project sponsors typically expect to reap very high returns on this portion of the investment. The Notes high return to sponsors for preconstruction investment can be manifested in purchase of part of the sponsorsÕ The author is Finance Secretary of India. The views equity at a substantial premium by new investors expressed in this paper are those of the author and not brought in at the time of financial closure. The same necessarily reflect the views of the government of result is achieved by charging a premium for fresh India. Acknowledgments are due to Gajendra Haldea, equity by new investors brought in at the stage of pro- Harinder Kohli, Edwin Lim, Ashoka Mody, and Teh ject implementation. Kok Peng for helpful comments on an earlier version of this paper. 1. In periods of high inflation even the periodicity of References the adjustment can become an important factor, since too long a delay may cause signiÞcant erosion in prof- International Finance Corporation. 1996. Financing itability. Private Infrastructure. Lessons of Experience Series 2. New licensees are typically either given monopoly No. 4. access to the market or face only limited competition. International Bank for Reconstruction and In India, for example, the market has been divided into Development. 1997. Global Development Finance, Vol. thirteen subdivisions (circles) for telecommunications 1. Washington, D.C.: World Bank. licensing. Bids have been solicited for one additional Johnston, Felton Mac, Ashoka Mody, and Robert supplier of basic (Þxed telephone) services in each cir- Shanks. 1996. ÒA House of Cards.Ó Project and Trade cle to compete with the existing public sector service. Finance (February): 40-42. Cellular telephones are entirely in the private sector, and bids have been solicited for two competing suppliers per circle.