Google+ Followers

Monday, 12 May 2014

The Case for Free Markets in India. Part 2: Roads and Highways

The Case for Free Markets in India

Part 2. Roads and Highways

Written by Dr. Seshadri Kumar, 12 May, 2014

Copyright © Dr. Seshadri Kumar.  All Rights Reserved.

For other articles by Dr. Seshadri Kumar, please visit http://www.leftbrainwave.com

Disclaimer: All the opinions expressed in this article are the opinions of Dr. Seshadri Kumar alone and should not be construed to mean the opinions of any other person or organization, unless explicitly stated otherwise in the article.

*********************************

Abstract

Socialism, India’s current economic system, has failed India in its 67 years of independent existence.  India must rapidly move towards free-market systems in every aspect of its economy to avoid sliding into a disastrous abyss.  The evidence for these assertions is presented in the form of a 12-part series. 

In this part, I discuss the poor condition of roads and highways in India, discuss the structural factors responsible for this state of affairs, and propose solutions to deal with these problems.

The report is broadly divided into two parts: one concerned with the poor quality, the systemic inefficiencies, the inherent corruption, and the reason for failures in government-built and government-operated city and local roads; and another concerned with the all-important highway sector.  I discuss the importance of the role of private industry in highway construction, the main causes of the current slow rate of construction, the key bottlenecks hampering the highway sector, and proposed solutions to quickly improve the situation.

Executive Summary

The roads sector in India consists of two distinct parts: local (city and village) roads, which are meant for low-load, low-speed passenger traffic, and highways which are meant for heavy traffic and high speeds.  There are serious shortcomings in the roads sector in India on both counts, which have seriously hampered productivity, efficiency, and quality of life for the last 67 years and continue to do so.

Local roads are managed by the public works divisions (PWDs) of state governments and city municipalities, and often are managed by sub-contracting parts of construction to small firms.  There are systemic problems of corruption and inefficiency that plague the planning, tendering, and execution of these projects, such as rigging of tenders, selection of tenders based on lowest cost, poor quality control, extensive bribery, and the use of item rate contracts instead of lump-sum contracts.  All of these can be improved by transparency, competition, and skill development.

Highways were also managed and constructed by the government until 1998, when the NDA government started the National Highway Development Project (NHDP) to vastly expand the national highway network, under the aegis of the nodal agency National Highway Authority of India (NHAI).  While there have been impressive gains in the Indian highways infrastructure, further expansion of the network is not possible unless groundbreaking reforms are carried out. 

The deficiencies in the highway sector are because of two main causes: financial bottlenecks and project execution delays.  In order to understand these, it is important to understand the financing models for highway construction: the EPC, BOT-Toll, BOT-Annuity, and VGF models. The financial bottlenecks are related to limitations faced by banks and financial institutions as well as construction companies. These bottlenecks can be addressed by opening up the playing field to more players internationally.

Project delivery delay has many components: administrative delays, such as obtaining clearances; engineering incompetence; poor dispute resolution; and land acquisition.  Some of these can be remedied by better administrative processes; some can be remedied by free-market measures, such as removing restrictions on foreign construction company participation in the Indian highway sector or offering better incentives for foreign players to enter the Indian construction space. 

One of the measures that have been introduced last year to deal with the issues surrounding land acquisition is the new Land Acquisition Bill of 2013.  This bill has wide-ranging ramifications that can seriously impede rather than advance the development of highways in the country, and should be repealed or amended as soon as possible.

In all cases, the solutions for improvements in the road sector are greater competitiveness, more transparency, more free enterprise, fewer restrictions, and better leadership – in all making a compelling case for free markets in the roads and highways sector.

The Sorry State of Roads in India

Everyone who has visited India after the monsoon has seen the potholes that abound in India.  In the 15 years that I lived in the USA, I have never seen incompetence on this scale.  Some might be tempted to counter my statement by saying that the US does not have monsoons; let me remind them that many parts of the US experience plenty of snowfall in the winter.  To keep the snow from freezing and becoming ice on the roads, which would make the roads very slippery, the government spreads salt liberally on the roads.  A quarter of the total consumption of salt in the US is for this purpose.  Salt, as everyone knows, is a very corrosive chemical.  At least in India, rainwater is pure water, and our roads disintegrate even with pure water.  The American roads have to handle huge quantities of saltwater; yet never have I seen a pothole there.  Potholes regularly cause miscarriages in pregnant women and deaths in India, yet this situation has never been satisfactorily addressed, despite the outrage that accompanies every such tragedy.

Another shocking bit of incompetence in India is how even the best roads are always uneven – you keep getting a slight bump every 20 seconds, even on roads like the Mumbai-Pune expressway and other toll roads.  In most asphalt-topped (tarred) roads in India, one can observe one half of one side of the road at a higher level and another half at a lower level.  Why?  What is the reason for such shoddy work?  In the USA, you can read a book without strain while being a passenger on a bus, even though traffic moves much faster than in India.  It is not that the technology is not available.  It is because there is no interest in India in doing good quality work, and no interest in enforcing good quality work.  The reason is that everything is managed by the government; and government infrastructure is inefficient

Recently, in Thane, near Mumbai, where I live, the local municipality dug one side of all the roads in the neighbourhood, causing huge traffic problems for a few months.  The ostensible reason was the laying of gas pipelines.  When the job was completed, rather than properly re-asphalt the dug roads, the municipality just filled the cavities with mud and stones, and did a half-hearted job of asphalting them.  A nice, smooth road had been replaced by a surface that looks like the craters on the Moon.  This is a typical story of shoddy work done in India – because there is no accountability when the government is entrusted with things.

The assigning of such responsibilities to the government also robs the citizen of his initiative.  Years ago, when I was living in Pune, the apartment complex I lived in was home to some affluent people, in a neighbourhood called Anand Park in the Aundh area of Pune.  When you opened the gate of the building, there was a huge pothole on the road right outside, so that in the rainy season it would fill up with water and to get out of the compound without getting your feet wet, you had to do acrobatics.  I asked one of my neighbours there why we did not get this repaired.  He replied that we could not even if we wanted to.  This is the province of the Pune Municipality, and only they are authorized to repair the road.  And they have submitted a request for them to take care of this, but no one has bothered.  Unless someone knew a politician high up, the problem could not be fixed.  That pothole is still present, nearly 9 years later.

See the problem with the government running things?  A group of well-off, private citizens cannot fix an immediate inconvenience even if they want to pay for it and can pay, because repairing roads falls under the Government’s responsibilities.  Left to themselves, this group of people would have hired a private contractor and finished the job within a week – and to the highest quality standards, because this would not be done “for free,” but would come out of the pockets of the citizens themselves, who would demand a job well done.

It is also the Indian experience that toll roads, which are built by private parties who are authorized to collect money in return for constructing highways in order to recoup their costs and their profit, are much better than government roads.  Why?  The reason is that government roads are considered “free” (even though they are not – they are funded from our taxes, and we are paying a “toll” to use them), whereas toll roads, such as the Mumbai-Pune expressway, are usable only on payment of a per-use fee, and so the idea that you are paying for it is very visible and immediate.  When you feel you are paying for something, there is a demand for accountability; but no one looks a gift horse in the mouth.

Time and Cost Overruns

The dreadful inefficiency, incompetence, and corruption associated with road-building in India that is common have lowered expectations so much in India that the few achievements of the road sector are hyped up way more than they deserve to be.  A prime example of this is the Bandra-Worli sea-link, a cable-stayed bridge spanning 5.6 km across the Mahim bay, part of the Arabian sea, in Mumbai, connecting the suburb of Bandra with south Mumbai.  The bridge, executed by Hindustan Construction Company, cost $270 million and took 10 years to complete.  This bridge has been hailed around India as an “engineering marvel.”  Compared with the abysmal state of most public works in India, it indeed may be a marvel that such a bridge was even completed.

“The Economic Times was critical of the Bandra–Worli Sea Link in every particular. First, the cost was not the projected 3 billion (rupees) but actually cost 16 billion (rupees) or about 430% cost overrun. Second, the project was 5 years behind schedule. Third, the supposedly reduction in commute time did not occur. Traffic bunched up at both ends of the Link causing nightmarish grid lock. The blame rests, as usual, on the notorious Indian corruption and political inefficiencies.”

Aside from the corruption and inefficiency, is it really a “marvel” in an absolute engineering sense?  Let us take another bay bridge, the Hangzhou bay bridge in China, for comparison.  This bridge connects the municipalities of Jiaxing and Ningbo in Zhejiang province, is 36 km long, cost $1.7 billion, and took four years to complete!  The longest span in the Bandra-Worli sea link was 250 m, whereas the longest span in the Hangzhou Bay Bridge was 448 m.  While the cost of the project seems to scale with the distance (36 km v/s 5.6 km), the fact that the project was executed in such a short time tells us what a true engineering marvel it is.  This is not taking into account the fact that building this long trans-oceanic bridge presented very difficult problems such as choppy waters (25 feet tall waves) and typhoons in an earthquake-prone region, the need to pre-construct large parts of the bridge and transport them to the mid-oceanic location, and unexpected difficulties, such as the discovery of poisonous methane gas on the sea bed below the bridge, that had to be solved before the bridge could be opened.

Road Construction Process in India in a Nutshell

What is the reason for this incredible inefficiency in the roads sector?  The reasons have to do with how contracts are awarded and how they are executed.  The first process in the construction business is the awarding of tenders.  The government, more specifically the public works department of the government, whose job it is to commission these bridges, roads, or other public works, floats a tender for the construction work for which contracts are to be awarded.  The lowest tender that meets the technical specifications is to be awarded the contract.

Rigging Tenders

On the surface of this, this is a fairly clear procedure.  But in fact, the process is rife with corruption.  The number of possibilities for corruption in the construction industry are too numerous to recount here, but can be found elsewhere in exhaustive references.  I will only mention a few principal avenues.  The corruption begins at the stage when the tender is being drafted.  There are many companies that can execute the project, and all of them can offer competitive bids.  If you are in charge of the ministry, and want to favour a certain company, and want to make sure they get the contract, you cannot leave it to chance, can you?  So what do you do?  You draft the tender in such a way that only one company will qualify.  For instance, you can say that the company should have executed at least 6 contracts in Malaysia and Singapore, and three in Uttar Pradesh and two in Tamil Nadu, if you know that only one company will fit those requirements (just using a hypothetical example here).  In return, they will give you a kickback which is a percentage of the contract value.  The immediate effect, of course, is that quality takes a backseat to who can give the biggest bribe. 

L1 Process: Lowest Bid Qualifies

The second way in which corruption and inefficiency enter the construction industry is the government requirement of the lowest bid.  This requirement often means that companies will deliberately try to bid a very low amount to get the government contract.  Often, these bids are impossible to execute for the bid amount and so are completely unrealistic.  In a bid to get the lowest bid approved and overlook the fact that it is practically impossible to execute the project for that cost, the decision-maker (typically a government minister) is bribed to approve the winning tender and to say that the tender is sound and the project can be executed for the specified amount. 

Having won the contract, the bidder is usually unable to execute it within budget and within time.  So he negotiates an extension to the project.  If this is a bridge or a road, the government cannot afford to cancel the contract when a half-made bridge or road is under construction.  There is the possibility of a fine, which is again waived through bribery.  Having promised the job for a much lower amount, contractors typically cut corners by using substandard materials or methods of construction that take less time and result in a less reliable final product.

Add to this the fact that each construction project requires a myriad different approvals and permits, and the process is infested with corruption.  The end result is shoddy work which gets approved all the way from concept to final completion without passing any proper standardized checks.  One further complication here is that often substandard quality is introduced by contractors deliberately so that they will be asked to do repairs or repeat the work, often at further cost to the taxpayer and benefit to the politicians and contractors.

Examine this entire chain of events, and one thing stands out.  Every act of corruption is predicated on the politician having power over decisions.  Remove this control of the politician over all these decisions, and you achieve two results simultaneously – you remove corruption, and you guarantee quality.  So it is the politicians’ discretionary powers over matters of this kind that are responsible for the lousy bridges, poor roads, buildings that collapse, and so on.

Quality Control

One may ask: how do you ensure quality in that case?  There are two ways to ensure quality.  The first is to have reliable third-party auditors of the work.  One can even have two competing auditors hired to examine the quality of the tenders, the quality of the progress on the work, and the quality of the final product.  These auditors must necessarily be private organizations, so that politicians have no power over them.  It is conceivable that the private auditors may also be bribed by unscrupulous contractors, and so it is necessary to mandate complete transparency of all activity on the web that any citizen of the country can examine.  In case of any illegality, the auditors can be taken to court.  And they have a reputation to worry about.

One may wonder if politicians can try to influence the private auditors to approve a particular contractor they favour.  But if the practice of withdrawing all discretionary powers from politicians is strictly followed, then they will have little to offer the auditors in return for any favors.

Indians have been conditioned since childhood to think that the government is benevolent and private industry is evil, and so many Indians might find my prescriptions strange.  It is very common to see Indians rant on the web about the “corrupt private sector” as the reason for all that is wrong with India, when in fact exactly the reverse is true.  The private sector has simply adapted, and adapted extremely well, to the state-instituted corruption apparatus that they had no way of really escaping if they wanted to do business - and now corruption has become the standard accompaniment of doing business with the government.

The “Bribery Fund”

Having worked in the private sector in India myself, I know the realities of the situation.  I myself have always been a technical person (engineering), and in one of my jobs I had to assist salespeople (a different company that partnered us) by accompanying them to prospective clients, presenting the technical details of our product and answering any technical questions the prospective client might have.  Once I had done my bit of convincing the client on the technical side, the sales representative would then take over and talk with the potential client on pricing, etc., to seal the deal.

In this process I got to know a lot of salespeople and interacted with them a lot, and learned a lot about the sales process in India.  One of the things I learned from the salespeople is that in most Indian government organizations, no matter how good your product is, you will NEVER effect a sale unless you bribe the approving manager.  One of the salespeople said his company had a specific “bribery fund” for dealing with Indian government organizations.  I asked him how much the bribe typically is, and he casually informed me it was between 2-5% of the contract value.  He told me most regretfully that he wished he didn’t have to do it, but the government managers make it very clear that the sale will not go through unless they get the bribe.

So, people who rail against Ratan Tata, Mukesh Ambani, and the like, and accuse them of corruption, need to realize how evil and insidious the Indian government corruption setup is, if it can force a man of such high principle as Ratan Tata to allow his people to corrupt themselves.  The corruption is not in Tata; it is in the Indian government.  And it is in the Indian government because of the discretionary powers of politicians.

Item Rate Contracts

Until recently, most of the contracts for road construction had been done using item rate contracts (see this for an example).  In item rate contracts, the expenditure on a project is micromanaged by the nodal agency.  So, for example, to get paid for the amount spent on cement, sand, tar, or a concrete mixer, the contractor must submit individual bills to the government nodal agency for approval.  The motivation for such a process is cost containment; however, this process has two major drawbacks: one, it leads to delays, as each expenditure must be approved individually, and two, it leads to increased corruption, as the government officer who has to sanction the expense can always demand a bribe in order to pass a higher expenditure than what was actually incurred, thereby causing both cost and time overruns.

An efficient alternative to item rate contracts is the lump-sum turnkey (LSTK) contract, in which the contractor is given stewardship of the entire project.  In this mode, his individual cost breakup is irrelevant to the nodal agency (e.g., NHAI or a state government agency), which now only cares that the project is executed in accordance with the specified quality standards and within the cost specified.  While this process is also amenable to corruption, it occurs, if it does, only once during the life of the project, and there is no necessity to wait for approvals for each expense.  Time overruns can, therefore, be greatly reduced using the LSTK process rather than item rate contracts.

In addition, LSTK contracts allow private players to be flexible about the way they allocate resources in order to be more efficient, provided the final quality of the project is maintained. For example, the contractor can spend more on material such as cement while optimizing costs on labor, as long as the total cost and quality objectives are met.

Economic Effects of Poor Roads

The poor condition of roads in India adversely affects the economy in multiple ways: it increases the time to market for goods and thereby raises costs for the end consumer; it does not allow vehicles to ply at the optimum speed, thereby causing excessive fuel consumption for cars and trucks;and creates a need for greater packaging of goods to protect them from the bumps of the road. The loss of efficiency due to the poor quality of roads is estimated to cost the nation Rs. 87,500 crores annually, according to a report prepared by IIM Calcutta for the Transport Corporation of India.  Of this, Rs 4000 crores is lost simply due to delays due to traffic jams and waiting in toll lines.  The average speed of traffic on the Mumbai-Delhi national highway is only 17 km/hr for trucks, and the average speed is estimated at between 23 km/hr and 30 km/hr.  This low speed is extremely inefficient in fuel consumption of automotive engines, which function most efficiently at a speed of between 45 mph (72 km/hr) and 65 mph (102 km/hr).  Unfortunately, the quality of surface of Indian roads is too poor to be able to drive traffic at such speeds, and much of India’s national highway network is still only 2-laned, meaning that traffic density will force the actual speed to be lower than what is technically possible given road conditions.

The Story of Highway Construction in India

Roads are a very important aspect of a country’s infrastructure.  Indian roads are responsible for 80% of passenger traffic and 63% of freight traffic in the country.  Of the approximately 3.3 million km of roads in the country, only about 2% of the total length is part of the highway network; however they carry about 40% of all road traffic.

Since Independence, highway construction was never accorded a priority until the late 1990s.  At the time of independence, in 1947, the total length of roads under the national highway network was around 23,000 km.  In the fifty years that followed, this increased to only 34,298 km, an increase of just 11,300 km in 50 years, or just 226 km/year.  

It was following the economic shock of 1991, and the subsequent focus on economic liberalization, that serious thought started to be given to increasing productivity and efficiency in India, and infrastructure development was seen as a very important enabler in improving the economic climate in India.  

Additionally, increasing growth in the country meant that the existing highways, which were designed mostly for passenger traffic and medium density freight traffic, was inadequate to carry the larger, multi-axle and tandem trucks.  The increasing prevalence of such trucks on Indian highways has led to rapid deterioration of the surface, necessitating substantial revamping of the existing highways.

The first serious steps towards a coherent policy towards improving highway infrastructure were taken by the NDA government of Atal Bihari Vajpayee in 1998.  This government initiated a plan, known as the National Highway Development Project (NHDP), to greatly expand the national highway system in India, with two key initiatives:

1.       The Golden Quadrilateral (GQ) project, which aimed at 4-laning/6-laning of the entire length of the national highway network that connected the cities of Mumbai, Delhi, Kolkata, and Chennai.

2.      The North-South and East-West Corridors (NS-EW corridors), which aimed at 4-laning/6-laning highways connecting Srinagar in the north to Kanyakumari in the south and Porbandar in the west to Silchar in the east.

By the time the NDA government left office in 2004, 80% of the work on the GQ project was complete (Ejaz et al., 2012).  Much less was accomplished on the NS-EW corridors project; however, this project was only approved in December 2003, just 6 months before the NDA government lost in the elections and quit office.

The UPA government that followed the NDA government understood the importance of the NHDP and continued the projects initiated by the previous government; however, the pace of road-building was much slower.  The GQ project was finally completed in 2012 – taking 8 years to finish the residual 20% of the project.  As of January 2014, only 5237 km of the 7142 km (73%) of the NS-EW project, that began towards the end of the NDA government, have been completed.  The NS-EW project is well behind schedule, since it was initially scheduled to be completed in 2009

The highway network has grown from 34,298 km in 1997 to 70,934 km in 2012, but the growth in this period has not been even.  Figure 1 shows how the network has grown in 5-year plan periods since 1997. 
 
Figure 1. Growth of Indian National Highway Network Over Five-Year Plans


It is clear that there has been a significant slowdown since 2002: the growth between 1997 and 2002 was 23,814 km, or 69%; the growth between 2002 and 2007 was 9,008 km, or 16%; and the growth between 2007 and 2012 was 3,814 km, or 6%.   It is a decline not only in relative but also in absolute terms.  The length of highway built between 2007 and 2012 amounts to just 763 km a year, or merely 2 km a day.  This is just three times the rate of highway construction in the dormant period between 1947 and 1997, and one-sixth the pace of the 1997-2002 period.  In contrast, the expected rate of highway building in order to achieve India’s goals is considered to be 20 km/day.  Some of the reasons for the delays in the implementation of these plans will be discussed herein.
The bottlenecks in the progress of highway construction are due to two main reasons:

1.       Financing, and
2.      Delays in Project Awards, Land Acquisition, Dispute Resolution, and Project Execution.

Both of these, in turn, can be related to regulatory bottlenecks caused by faulty and regressive policies in the country.  I will discuss these in turn.

1.      Financing

Models: EPC, BOT-Toll, BOT-Annuity, and VGF

Highways are not cheap.  The 9044 km of highways that were built in the eleventh five-year plan (2007-2012) cost the Indian government Rs. 1,03,814.17 crores, or (at $1 = Rs. 60) $17.3 billion.  The government cannot afford to assume the entire cost of highway building on its own.  Left to finance the cost of highways on its own, the pace of highway construction will necessarily be slow (as it was in the period before 2000), especially for a developing country like India.  However, the gap in development that the country needs to bridge is substantial, and cannot brook the large delays that will be necessary if the government has to raise the money for development on its own.  How can this be addressed? 

To answer this, it is necessary to understand the different financial models that are used in the construction industry for large projects.  These are the Engineering, Procurement, and Construction (EPC) model and the Private-Public Partnership (PPP) models - the Build-Operate-Transfer (BOT) model and its variants such as BOT-Toll and BOT-Annuity, along with enabling models such as Viability Gap Funding (VGF).

In the EPC route, a private contractor is asked to design the highway, procure materials for construction, execute the construction, and hand over the finished project to the nodal agency.  The payment for the entire project is agreed upon in advance and paid to the contractor by the nodal agency in instalments.  The contractor is responsible for the quality of the project and is subject to periodic verifications and checks.  The financial consequences are that the cost for the entire project has to be borne by the nodal agency, and hence by the government.  However, the owner (the nodal agency) is protected from cost overruns because the cost is agreed in advance – the owner is not responsible for changes in the cost of labor or materials.  There is an incentive for the contractor to finish the project within time and cost to protect his own finances.  There are also penalty clauses in case the project is not delivered within the time specified in the contract.  However, if there is any change in the scope of the project, the cost differential has to be borne by the owner.  Once the highway has been handed over to the owner, the contractor has no more responsibility for it, except for performance guarantees; the regular maintenance and upgradation of the highway are the responsibility of the owner.

In the BOT model, the private entity agrees to build the highway, and then operate it for a fixed period of time as specified in the contract.  The payment for the building of the highway is not made by the owner in advance or during the building of the highway.  The cost of building the highway is the responsibility of the private contractor.  They can raise the funds through debt – by borrowing from banks – or through equity – by inviting financial partners or venture capitalists.  Once the highway is built, the manufacturing costs are defrayed either by allowing the concessionaire (as the contractor is called, because they sign a “concession agreement” with the government agency) to charge toll fees from those using the highway for a fixed, pre-determined amount of time – typically 20-30 years (known as the concession period) – this is called the Build-Operate-Transfer-Toll model; or by the nodal agency paying a predetermined annuity to the concessionaire for the same pre-determined 20-30 years, typically in six-month instalments – this is called the Build-Operate-Transfer-Annuity model.  In both BOT-Toll and BOT-Annuity models, the responsibility for the maintenance of the highway for the concession period (20-30 years) is that of the concessionaire.  At the end of the concession period, the concessionaire transfers to the owner (the government) a well-maintained highway. 

The owner incurs NO COST in the building of the highway in the BOT-Toll model – the funds for building it are raised by the concessionaire using equity or debt and recovered using the toll collected in the concession period.  There is no limit on how much toll can be collected, though the tolling rates are fixed in advance in the contract, with allowances for inflation-linked increases.  The actual toll amount collected depends on the number of vehicles using the highway, and there is no limit on that.  This is therefore a very attractive model for cash-strapped countries like India which need to extensively improve their highway infrastructure in a short period of time.  It is also very attractive for the concessionaire, because if the highway being built is highly trafficked, the revenues from toll collection can lead to substantial profits.

It is because of this last-mentioned consideration that not all highway projects are suitable for the BOT-toll model.  In particular, in many rural stretches, not many vehicles may frequent the highway once it is built, and so toll collection may not be a very good vehicle for cost recovery.  In such cases, private companies may be wary of incurring the upfront cost of building the highway and not being  able to recover the cost later.  To address this problem, two solutions have been adopted by the Indian government.

One is the use of BOT-Annuity contracts.  In these contracts, the concessionaire recovers the cost of the highway construction not through tolls, but through regular annuity payments for the next 20-30 years (the concession period).  This model is thus safer for the concessionaire, as they do not have to worry about the vagaries of toll collection.  However, in this case the entire financial burden shifts back to the state, just as it does in the EPC model.

Thus a second, intermediate option has also been used, that of using Viability Gap Funding (VGF).  The financial viability of the project is examined at the beginning, and the potential for revenue generation through toll collection is assessed before the project is finalized, and if a shortfall is anticipated, then the nodal agency is empowered to contribute 20% of the project cost to bridge the gap between the actual cost and the estimated recovery.  This is known as viability gap funding (VGF).  In addition, if even this is found to be inadequate, the VGF model allows the state government of the concerned state in which the highway is located to contribute up to 20% more of the project cost so as to make the project more attractive to concessionaires who might be interested in exploring the BOT-Toll option but are worried about toll under-recovery.

There have also been some innovative funding mechanisms explored, such as a hybrid PPP model involving both grant funding from the state as well as annuity payments in a BOT-annuity scheme.  This is motivated by the fact that borrowing costs for the public sector are much lower (as in the case of low interest rate loans from institutions like the World Bank and the Asian Development Bank) than borrowing costs for the private sector (who have to borrow at high, commercial rates).  An example of a project using such an approach is the Outer Ring Road project near Chennai, in which the Tamil Nadu state borrows at lower cost and consequently pays lower annuities to the private player after construction of the highway.

Bottlenecks in Financing

The Vajpayee government recognized that the Indian government could not develop the necessary infrastructure on its own and decided to involve private players in large measure in the construction of the GQ and NS-EW projects.  However, in this early phase of highway development, the financing model followed was predominantly the EPC model, which required the state to fund most of the expenditure needed for the projects.  In the early years of liberalization, between 1991 and 2004, only 86 projects were awarded using the PPP models among all infrastructure projects with a total value of Rs. 34,000 crores (~ $5.7 billion @ $1=Rs.60).  Since 2006, the share of projects awarded under the PPP model have greatly increased.  As of 2012, the government had 758 PPP projects across all infrastructure sectors costing Rs. 3,83,300 crores (~ $64 billion) in progress. (source here).

The tenth five-year plan (2002-2007) expenditure (actual) on infrastructure amounted to Rs. 9,06,1,00 crores ($151 billion), of which 25% came from the private sector.  This increased to Rs. 20,54,200 crores ($342 billion) in the eleventh five-year plan (2007-2012), of which the share of the private sector was 36%.  In the twelfth five-year plan, the spending on infrastructure was estimated to be Rs.40,99,200 crores at 2006-7 prices, which, assuming an annual inflation rate of 5%, translates to approximately Rs. 65,00,000 crores (~ $1 trillion) at 2014 prices, of which the share of the private sector is estimated to be 48%.

The expenditure on roads is projected to increase from Rs. 4,53,100 crores (~ $76 billion) in the eleventh five-year plan to Rs. 10,79,300 crores (~ $180 billion) in the twelfth five-year plan.

The government cannot be expected to finance these massive outlays on its own in such tight financial times, and hence the share of the private sector has greatly risen in successive five-year plans.  Even factoring in the nearly 50% participation of the private sector, it is not easy for the government to fund the remaining 50% of the project costs on its own, even with the availability of cheap borrowing resources, such as World Bank and Asian Development Bank loans, which are granted on extremely easy terms – sometimes even interest-free for a long period (these resources are not available to private players, who have to borrow at significantly higher rates) – especially because, as the Deloitte report on Indian Infrastructure (2014) states: “Central Government has to contend with ... massive expansion on programmes aimed at social entitlements.”

The aforementioned Deloitte report also contends that, to put it bluntly, given existing resources and policies, the twelfth five-year plan infrastructure goals are unrealistic, because there is a gap in debt funding.  The report analyzes the debt contribution of the required funds for the infrastructure development as a total of 32,36,300 crores (~ $539 billion), of which the public sector component is Rs. 10,69,300 crores (~ $178 billion) and the private sector component is Rs. 21,67,000 crores (~ $361 billion).  As against this, the total available debt (comprised of loans from commercial banks, external commercial borrowings, insurance funds, and infrastructure finance companies) is only Rs. 13,33,700 crores (~ $222 billion), leading to a debt gap of Rs. 19,02,500 crores (~ $317 billion).  Not only is this shortfall true of the twelfth five-year plan, it is also true of past years.  For example, in the roads sector, there was a shortfall in funding of Rs. 1,30,100 crores ($21.7 billion) in 2011-12, and of Rs. 1,40,100 crores (~ $23.3 billion) in 2012-13 – a 23% shortfall in funding for the roads sector.

In light of this funding crunch, the spending on wasteful welfare schemes like MNREGA, which costs typically Rs. 50,000 crores a year, and therefore Rs. 2,50,000 crores (~ $41 billion) over a five-year plan; like the Food Security Bill (FSB), which is estimated to cost Rs. 3,14,000 crores a year, and therefore Rs. 15,70,000 crores (~ $262 billion) over a five-year period; like the Right to Education, which is estimated to cost Rs. 1.78 lakh crores (~ $30 billion) over a five-year period, need to be seriously re-examined.

Reasons for the Funding Crunch

Why is there a funding crunch in the debt space?  One of the main reasons is that the majority of loans are obtained from Indian banks.  These are subject to RBI regulations, and face two main constraints:

1.       Asset-liability mismatches
2.      Sectoral exposure limits of banks

Asset-liability mismatches have to do with what are known as the “tenor” of funds deposited in and loaned out by banks.  The tenor of assets is the amount of time that the asset can remain in the bank – a shorter tenor asset can be withdrawn in a short time, and a longer tenor asset is obligated to remain in the bank for a long time.  So, for example, many fixed deposits operated by banks constrain the funds to remain in the bank for three years.  Individual savings accounts have extremely short tenors, because the entire amount can be withdrawn without notice.  In contrast, infrastructure projects stretch over at least 5 years, often longer.  Hence there is a mismatch between the tenors of banks’ assets and the loans which can be granted to infrastructure.  To maintain adequate balance in the banks in case investors want to pull out their money, banks must maintain adequate assets in different tenors.  This limits the amount available for infrastructure funding.

The RBI mandates that only a certain percentage of a bank’s assets can be exposed in loans to any particular sector – be it roads, transport sector, hospitals, and so on.  The reason for this prudent regulation is that if that sector fails, it will not catastrophically affect the position of the bank and will not threaten the funds of its investors.  When the rush towards PPP started in 2006, banks had adequate finances for the projects that were funded.  However, in just a few years time since then, most banks are today close to reaching their sectoral limits and will soon be incapable of granting more loans in the roads sector (and in most other sectors as well, since all sectors of India’s economy are expanding).  Put another way, banks are out of money to lend. 

In fact, this limit would have been reached much earlier, had it not been for the fact that many projects in the eleventh five-year plan period (2007-2012) not been delayed due to other reasons such as delays in the award of contracts, and delays in land acquisition, both of which will be visited later in this article.  As the report in the “Building India” series by McKinsey, on “Accelerating Infrastructure Projects,” published in 2009 (downloadable here), says, 

The core infrastructure sectors are on course to a deficit of USD 150 billion to USD 190 billion in financing during the Eleventh Plan period.  This deficit is equal to around 35% of the investment planned in core sectors over this period.  However, the shortage of funds has not been acutely felt during fiscal years 2008 and 2009 because the slow pace of tendering and uptake of projects has suppressed the sector’s demand for capital.

In addition, certain avenues of long-term funding are subject to regulations (again, prudential).  These are pension funds and insurance companies.  To safeguard the interest of pensioners and those paying insurance premiums, these funds face regulatory restrictions in their investment in infrastructure, even though the tenor of these assets matches infrastructural needs very well.  The government has tried to tap the bond market, by allowing tax exemptions under Section 80CCF to the tune of Rs. 20,000 per year for long-term bonds, and the Deloitte report suggests that more can be done in this direction.

Solutions to the Funding Problem

How can these problems be addressed? 

Clearly, the Indian banking system is saturated and cannot further fund infrastructure projects in India, or at least not much further.  If India has to achieve its ambitious goals elucidated in the Twelfth Plan, much more needs to be done in providing avenues of finance to the construction business.

Two ways present themselves quite clearly.  One is the entry of large foreign construction companies, such as Bechtel, into the Indian construction space, which has simply not happened for various reasons, most of them regulatory.  A company like Bechtel can more easily fund a venture with equity than a smaller Indian company.  Two, foreign institutional investors can pump in much-needed funds to boost infrastructure development in India.

As the Ernst and Young report, “Accelerating Public-Private Partnerships in India,” (2012) discusses, “Foreign direct investment (FDI) of up to 100% is permitted in greenfield infrastructure projects under the automatic route.  In the case of existing projects, FDI under the automatic route is permitted up to 74% and FIPB approval is required beyond 74%.” The report is also optimistic in its outlook on FDI, mentioning that “Total FDI increased from US $5.03 billion in 2002-03 to US $27.02 billion. Over the next two years, India could attract FDI worth US $80 billion.”

The same report also talks about Foreign Institutional Investment (FII), which is important considering the capacity constraints of the banking sector in India mentioned earlier: “The GoI is reportedly in talks with the regulatory authorities to allow infrastructure finance companies to issue bonds to foreign investors for the purpose of raising infrastructure finance in the country.  The GoI had earlier raised the limit on FII investment in corporate bonds of duration of more than five years issued by companies in this sector.”

Encouraging though these words may be, the reality on the ground today is that foreign participation in the highways sector is minimal.  A look at the list of contracts awarded under the NHDP for its Phase III shows that most of the contractors are Indian, and that foreign companies are mostly present as consultants.  The same pattern is seen in projects under Phase IV and Phase V.  Clearly, more needs to be done regarding the participation of international majors in injecting much-needed equity and expertise into Indian road-building, and India needs to loosen its regulatory framework if it wants to achieve its infrastructure goals as per the Twelfth Five-Year plan.

Even under the existing regulatory framework, it is clear that some foreign construction companies do bid for and are able to work on projects – such as companies from Malaysia and the Persian Gulf.  So why are international companies wary of swimming in Indian construction waters?

One answer perhaps is the long delays in project approvals and land acquisition, which tie up funds for years with no benefit.  I will discuss this in what follows.

2.     Delays in Project Awards and Land Acquisition

Although the PPP model began in earnest in India in 2006, it has been bogged down in delays of various kinds.  Delays have occurred both in project awards and in project execution.

In 2010-11, only 56% of the target length that was to be awarded by NHAI was actually awarded; in 2011-12, the figure was 51% (as quoted in the PWC report: The Road Ahead: Highways PPP in India).

In addition, project execution has also faced several delays.  In 2009-10, the target for road construction under NHDP was 3165 km; what was actually achieved was only 2693 km, or 85%; in 2010-11, the target was 2500 km, and what was actually achieved was only 1780 km, or 71% (source: PWC Report).

The same PWC report states that the minimum delay in projects was 4 months and the maximum delay was 37 months, and the average delay was 22 months.  Additionally, an examination and analysis of the NHAI website on the project implementation status of Phase I of the NSEW project shows that the minimum delay on the projects was 0 months, the maximum delay was 78 months (6 and a half years), and the average delay was 46 months (3 years and 10 months) for all projects, including North-South and East-West sections.  Of these, the minimum delay in the North-South section projects was 0 months, the maximum delay was 75 months, and the average delay was 30 months; the minimum delay in the East-West section projects was 0 months, the maximum delay was 78 months, and the average delay was 54 months.

Causes of Delays

McKinsey, in their detailed report, “Building India: Accelerating Infrastructure Projects,” have analyzed the causes of these delays very carefully.  Based on their findings, the following are the main causes of delays in project delivery:

1.       Tendering unviable projects: Projects that are unviable because of excessive scope, poor or dated cost estimates, and tough financial stipulations (such as the possibility of termination of concession if traffic exceeds a threshold level),
2.      Using item-rate contracts instead of LSTK contracts,
3.      Slow pre-tendering process, involving a multitude of approvals, including cabinet/ministerial approvals,
4.      Land acquisition delays,
5.      Poor dispute resolution processes,
6.      Poor performance management, including poor transparency, lack of meaningful incentives for quality or timeliness, and absence of clearly-defined consequences in case of poor performance or delivery,
7.      Poor availability of skilled and semi-skilled manpower,
8.     Weak risk-management skills,
9.      Sub-par design and engineering skills, leading to an absence of a value engineering mindset (Lean principles, for instance), and
10.  Lack of best-in-class procurement practices, such as demand consolidation, preferred relationships through frame contracts, and joint cost reduction.

The interested reader is directed to the aforementioned report for details on all these points, but I would like to focus on a few of these areas in a search for solutions.  It will be clear from a perusal of the list above that the identified lacunae come from three sources:

1.       Bad Contracting Practices (1,2,6)
2.      Red Tape and Bureaucracy (3,4,5)
3.      Engineering and Financial weaknesses (7,8,9,10).

Solutions to Delays in Project Delivery

Of these, bad contracting practices are the province of the nodal agencies such as NHAI, and the McKinsey report details some excellent suggestions on how these can be improved.  In particular, attention needs to be paid to selecting contractors on the basis of BOTH cost and quality in preference to the current practice of selecting the lowest tender.  Part of the problem is also an unfamiliarity with the international practices of commercial construction and the kinds of contracts that will be attractive.

Engineering weaknesses can be addressed in a variety of ways.  The problem of shortage of skilled and semi-skilled manpower can be addressed by the establishment of dedicated institutes for the construction industry financed by the construction industry itself, with a view to inculcating world-class skills and practices in the graduates of such institutes, and with active participation from top construction companies and civil engineering departments from all over the country.

The problems of poor engineering practices, absence of Lean techniques, weak risk-management strategies, lack of a value engineering mindset, and poor finance strategies, such as lack of best-in-class procurement strategies, can all be addressed by tapping into the experience of world leaders in the construction industry, for whom all these are standard best practices to be followed in all projects.  An examination of the list of contractors who are working on projects under the aegis of the NHDP Plan IV, for example, (projects which are all in the implementation phase currently), shows that, apart from two companies based in Oman, all the 38 projects are being executed by Indian construction companies.  Although the government has stated that it allows 100% FDI in construction, this has not translated into much demand from foreign companies.  The move to allow 100% FDI in construction is also a recent move and probably accounts for the low presence of foreign construction majors in the Indian highway space.

Presence of foreign construction companies in the Indian highway sector has two beneficial effects: the introduction of best practices in the construction industry and their widespread adoption by the Indian construction industry as a whole by osmosis; the higher levels of capital that foreign construction majors possess, which will greatly alleviate the financial crunch that the highway sector in particular, and the infrastructure sector in general, is currently facing, because of reasons already stated.

The issue of dispute resolution was addressed by the BK Chaturvedi committee, which suggested that dispute resolution be handled in a two-tier manner: Category A disputes, involving amounts less than Rs. 10 crores or 5% of contract value, whichever is lesser, to be handled by a committee consisting of a retired High Court Judge, a former CAG, a vigilance commissioner, and a technical expert; and Category B disputes, where the amount involved is between Rs. 10 crores and Rs. 100 crores, in which case the recommendations of the existing arbitration tribunal should be accepted.  The result of this two-tier separation of the dispute resolution process is expected to greatly speed up resolution of pending cases, and the recommendations have been accepted by the ministerial panel.

The Problem of Land Acquisition in India

That leaves us with red tape and bureaucracy, probably the biggest cause of project delays in the Indian infrastructure industry in general and highways in particular, because of the large areas that highways cover. Highway-building inevitably requires displacing people from the places where they live or farm; or, alternatively, destroying forest regions; or requiring people to vacate slums so they can be destroyed and space created for highways, and rehabilitating them.  Villagers may have to part with fertile land in order to make way for highways and need to be compensated with equitable land elsewhere so they can continue in their hereditary occupations. 

Worldwide, the standard is that more than 80% of the land is acquired by the government before a private organization is asked to work on the project, and the remaining 20% is acquired during the project.  In India, often projects are awarded with just 30% of the land having been acquired, which then leads to problems as people refuse to leave the land or construction is blocked by agitations.  In 2009, it was reported that more than 150 of 187 projects were behind schedule, mainly because of problems with land acquisition.  Mr. Kamal Nath, Union Minister for Roads, Transport, and Highways, has been reported to say, “the land acquisition problem is the major factor behind project delays as multiple authorities are involved.”  Several highway projects in the east, in Bengal and Assam, were held up because of agitations against them in 2012.  In the same year, the much-heralded Yamuna Expressway was finally inaugurated after a long history of agitations by villagers against the project, on issues such as alleged inadequate compensation for the land acquired by the governmentaccess to the highway for the villagers with service roads, foot overbridges and underbridges to enable local residents to cross the highway, and the high cost of the toll charged.  In August 2012, the Union minister of state for road transport and highways, Tushar Chaudhury, said “Fifty-eight ongoing national highways projects are delayed for want of land acquisition, inter-alia, including shifting of utilities, environmental clearance, etc.”  In August 2013, the NHAI said it was scrapping highways worth Rs. 4000 crores and amounting to about 420 km because of difficulties in land acquisition.  The highways were to be located in Goa and Kerala.  In addition to these, more than 30 projects were in difficulty and were being delayed due to difficulties in land acquisition.

In the past, the government’s approach to land acquisition has been ham-handed, driven by an archaic and insensitive land acquisition act - a legacy of British rule, which allowed central and state governments to indiscriminately use the power of eminent domain to dispossess people, with unclear guidelines on what kind of compensation was adequate.  Further, the act allowed the state to bypass the normal procedures that it itself prescribed for land acquisition in the event of an “urgency” without ever defining clearly what comprised an “urgency,” with the result that almost every land acquisition was carried out under the guise of an “urgency,” thereby completely bypassing the normal procedure of consultative democracy and grievance redressal.  The 1894 Act did not specify proper resettlement procedures either.  The net effect of all this was that most land acquisition was caught in endless litigation, causing huge delays in land acquisition for all major infrastructure projects.  These delays are one of the main reasons why foreign investors and construction companies hesitate to enter India’s construction arena – for fear that funds might remain locked up for years because of delays in getting approvals and delays due to litigations on land acquisitions.

The 2013 Land Acquisition, Rehabilitation, and Resettlement Act

To alleviate these difficulties, the UPA-2 government came up with a new land acquisition bill, the The Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Act, 2013, hereinafter referred to as the LARR.  The idea of the LARR was that because most of the litigation in infrastructure cases concerned inadequate compensation and resettlement provisions, this legislation would remedy the situation adequately and prevent future bottlenecks due to litigation.  Unfortunately, it appears that the remedy is worse than the illness.

Some of the central features of the LARR are (full details here):

1.       For compensation, the highest estimate of the market value of the land will be multiplied by a factor of 4 in rural areas and by a factor of 2 in urban areas.

2.      For rehabilitation, the following allowances will be given:

a.      A subsistence allowance of Rs. 36,000 for the first year,
b.      One of the following, at the choice of the affected party:
                                                              i.      A job for a family member
                                                           ii.      A one-time, upfront, lump-sum payment of Rs. 5,00,000
                                                         iii.      A monthly annuity, totalling Rs. 24,000 for the year, for the next 20 years (inflation-linked)
c.       An additional, upfront, resettlement allowance of Rs. 50,000
d.      An additional, upfront, transportation allowance of Rs. 50,000
e.      A new home of not less than 50 square meters if a home is lost in a rural area
f.        For SC/ST families, additional grants of
                                                              i.      2.5 acres per affected family
                                                           ii.      Additional assistance of Rs. 50,000
                                                         iii.      Free land for community and social gatherings
g.      25 additional community services at the expense of the land acquirer to displaced families, such as schools, health centres, roads, safe drinking water, child support services, places of worship, burial and cremation grounds, post offices, fair price shops, and storage facilities.

3.      For consent, the new law requires the consent of at least 80% of all affected families in the case of private projects and 70% of all affected families in the case of public-private partnerships.  Interestingly, consent is NOT REQUIRED when the land is acquired directly for public purpose by the government.

4.      For due process, the new law requires, in turn, the following steps to be followed:

a.      When land is proposed to be acquired, a Social Impact Assessment (SIA) is to be completed within 6 months, in consultation with the Gram Panchayat, Gram Sabha, Municipality or Municipal Corporation, as appropriate, and after conducting public hearings in the affected area to ascertain the views of the local populace.  The SIA authority is also to prepare a Social Impact Management Plan to discuss ameliorative measures to deal with the social impact that has been ascertained.
b.      The SIA will be reviewed by a multi-disciplinary expert committee consisting of two non-official social scientists;  two representatives of the local panchayat, gram sabha, municipality, or municipal corporation, as the case may be; two experts on rehabilitation; and a technical expert in the subject related to the project.  This expert committee is to rule within two months whether the project should proceed or not, on the basis of the SIA report.
c.       Within 12 months of the report of the expert committee, the District Collector will issue a preliminary notification on the proposed acquisition, arrange for widespread dissemination of the notice, invite comments and criticisms, and arrange for hearings to discuss proposed concerns by citizenry.  The period of 12 months can be extended on the discretion of the Collector if, in his/her view, the circumstances warrant the delay.
d.      Within 12 months of the preliminary notification, all important concerns will be addressed, and a final declaration on land acquisition will be issued.  This, too, can be extended on the discretion of the government.

In addition, 26 substantive amendments to the LARR were passed after the passage of the bill.  Notable among these are a retrospective clause for providing benefits to claimants on projects that were already complete; a requirement for the government to deposit money in lieu of agricultural land in case they are unable to find equivalent agricultural land to give to affected parties; a waiver on stamp duty and income tax on any compensation received; and a provision to share 40% of the proceeds in case that land acquired was not used for the purpose claimed but resold to a third party (as opposed to 20% in the original draft of the bill).

Implications of the 2013 Land Acquisition Act

The LARR was generally seen to be a setback for highway construction in India. There are many reasons why this is so.  While the earlier land acquisition act of 1894 was definitely arbitrary and draconian, and was skewed in favour of the government, the new LARR swung the pendulum all the way to the other side in favour of the landowners.  Here are some of the main criticisms of the LARR:

1.       Excessive compensation for landowners.  As the Wikipedia page on the LARR explains, using a conversion rate of 45 rupees to the dollar, if 1000 acres are to be acquired, at a rural rate of Rs. 2,25,000 per acre (USD 5000), the total costs of land acquisition would be

a.      Land ownership costs of Rs. 90 crore (USD 20 million),
b.      Land owner entitlements of Rs. 6.3 crores (USD 1.4 million) + 100 replacement homes,
c.       Livelihood loser entitlements of Rs. 365 crores (USD 70 million) + 1000 replacement homes,
d.      Leading to an effective average cost of land of Rs. 41 lakhs/acre (USD 91,400/acre) plus replacement homes and additional services such as schools, health centres, etc., as specified in point 2(g) of the previous section.  Even assuming a much lower base price of pre-acquisition land – at Rs. 22,500/acre (USD 500/acre), the average cost of land works out to Rs. 33,03,000/acre (USD 73,400/acre).
e.      This can be compared with prices of farmland elsewhere in the world.  For example, US farmland varies between USD 480/acre and USD 4,690/acre, with an average value of USD 2140/acre. The average cost of farmland in Europe was USD 2,430/acre.

2.      Long timelines for land acquisition.  As can be seen from the previous section, the land acquisition process mandates, at a minimum, a 6-month timeline for the SIA, a 2-month timeline for the expert committee report on the SIA, a one-year period for the preliminary notification, and a one-year period for the final declaration – a total of 2 years and 8 months.  However, it should be noted that both the period of the initial notification and the period of the final declaration can be extended by the government at its own discretion if the circumstances warrant them.  In particular, this means that if there is a lot of concern among the displaced people, the discussion on the proposed project could easily extend to multiple years on both time windows, leading to disastrous time and cost overruns on highway projects.

3.      Delays in Project Delivery. The requirement of 80% of all affected parties for private projects and 70% of all affected parties for public-private partnerships, without allowing the exercise of eminent domain to expedite the process, could further greatly delay projects.

4.      Uncertainty due to Retroactive Provisions. Further, the land acquisition bill, on the discretion of the government, would also apply in some projects retroactively, thus further creating uncertainty and inflating costs.

It should be noted that, as passed in 2013, the LARR does not apply to the highway sector; but that is only a temporary phase.  To underline this, in January 2014, Jairam Ramesh, the Union Minister for Rural Development, wrote to several ministries, including the Ministry for Road Transport and Highways, to remind them about the need to change their laws to be compliant with the LARR.  In the case of the Ministry for Road Transport and Highways, that law is the National Highways Act, 1956.  So, although the LARR does not currently refer to the highways sector, that is no cause for comfort, because in a short while the highway sector has to fall under the umbrella of the LARR.  Further, in an interview, Mr. Ramesh dispelled any hope that a new NDA government would roll back the LARR. As Mr. Ramesh said, “Almost all political parties have consensus on the land acquisition bill because it is going to help the farmer. Parties including BJP, SP, BSP and of course Congress have praised the bill and accepted the need of amendments for an effective implementation of the act.”

The LARR is set to further intimidate construction majors from taking up highway construction projects in India, and is giving the jitters to construction companies that are already involved in projects under implementation.  For example, the Delhi-Jaipur expressway is anticipated to cost three times what was estimated because of the impact of the LARR. 

The higher costs of land acquisition under the LARR will mean that the financial viability of projects, which were already in question even with the much more liberal land acquisition laws, will now be much worse.  As has already been discussed in this report, BOT projects often do not find takers because the ROI on those projects may not be adequate – builders may not be able to recover the cost of construction and their expected profit with the total toll amount they can expect to collect.  With much higher project costs due to the LARR, the toll amount that operators will have to fix on the highways they build may rise significantly, and this may mean that the public may not find it worth paying so much to travel on those highways.  An example of a highway that is already at the point where the average Indian will hesitate to pay high tolls is the Yamuna expressway, which is currently charging a toll of Rs. 2.10/km for cars and jeeps on the 165 km highway – which means that a car or jeep travelling the entire stretch would have to pay about Rs. 350.  For a multi-axle truck, the rates are much higher, at Rs. 10.10/km, which means that for a round-trip, a heavy truck will have to pay Rs. 2,560.  These are high costs for Indian motorists.  If a project like this is hit by inflated costs due to the LARR that raise the actual cost to 3 times their present cost, motorists will simply not use them, which means the projects will be financially unviable.

In an atmosphere where much-needed highway projects are already not finding bidders because of viability concerns, which is causing contractors already to opt for annuity-based projects instead of BOT-based projects, the LARR is a spanner in the works that threatens to completely halt the progress of highway construction in India.  The only viable option in India for bridging the huge gap in highway infrastructure is the BOT model of PPP; but if land acquisition costs are so high, tolling may well be impossible, and we will have to settle for a much slower rate of highway construction that is determined more by budgetary limits of the state, where contractors are willing to work only on EPC or Annuity-based mode with generous annuities and high levels of VGF, so that there is no risk to them financially.  This could be crippling for the growth of the highway sector and could very well make the goals of the twelfth plan impossible to achieve.

It may be well worth discussing some impacts of the existing inefficiencies in the infrastructure sector on the economy without factoring in the impact of the LARR.  The McKinsey report mentioned previously has done exactly this analysis.  The analysis is not limited to the highway sector alone, but considers all infrastructure in the country, including ports, airports, irrigation, power, railways, storage, gas, and telecom.  This report, written in 2009 (before the introduction of the LARR), estimates that if the then-current inefficiency trends were to continue, India could suffer a GDP loss of USD 200 billion in FY 2017, which would be a loss of 1.1% in GDP growth rate.  In addition, the McKinsey report estimates that India’s economy could lose up to USD 160 billion in 2017, by forgoing the industrial productivity impact of infrastructure.  These are serious loss estimates, and don’t even include the debilitating impact of the LARR.

Concluding Thoughts

The story of roads and highways in India is a chequered one.  For 50 years since independence, Indian road construction was stuck in the wheels of a socialist machine that promoted corruption, inefficiency, and substandard roads.  This led to standard corruption processes such as using a lowest cost bid to select contractors for projects but rigging the system so that a low initial cost was proposed and projects were delayed forever, leading to cost and time overruns.  The players were well-entrenched and saw no reason to change the system.

All that changed with the perceived need to rapidly develop the country’s highway network in the mid-1990s in order to achieve higher GDP growth rates, and India finally started taking baby steps towards a free market structure in the roads and highways sector.  The NDA government, which kick-started the Golden Quadrilateral and NSEW projects, realized that it could not accomplish these goals by just public funding and execution, and that it needed to involve the private industry in order to make this happen.  

However, the early modes of highway funding were primarily done using the EPC mode, and it was only after a few years of government spending that the bureaucrats in the ministry for road transport and highways seem to have realized that using government funds exclusively for funding highway projects was not sustainable in order to achieve the kinds of growth in highway length that they were hoping for.  

This triggered a move towards BOT-Toll and BOT-Annuity projects, and the formation of the BK Chaturvedi committee, which recommended the “waterfall mode” of financing – try to tender projects with BOT-Toll first, then try BOT-Annuity if BOT-Toll had no takers, and finally use EPC if neither approach had takers – which is the standard for highway tendering today in India.

The journey taken by the Indian government towards the free market since 1998 is significant and needs to be appreciated.  The initial model of highway construction was a highly state-dominated one: where the funding, design and construction was overseen by state PWD departments, with item-rate contracts parcelled off to individual contractors, where the prices for each line item purchase had to be verified and approved by the government.  This gave way during the first two phases of the NHDP to an EPC LSTK model, with much less participation from the state and much more control in private hands.  In this model, the state let go of control of the design and construction space, but still retained control of funding and operations.  This yielded, in turn (and driven by financial realities) to a model that surrendered both finances and operational control to private entities in return for a finished highway to be transferred to the government at the end of a concession period – the BOT-Toll approach – which is now the preferred route for highway construction in India, with BOT-Annuity being used as a fallback option.  The resulting benefit and the achievements in this sector because of the gradual move to the market is there for all to see – a doubling in the length of national highways between 1997 and 2012 relative to the total highway length in 1997.

The increasing participation of the private sector can also be seen in the fact that the tenth five-year plan only had 25% private participation, which increased to 36% in the eleventh five-year plan and 48% in projected private participation in the twelfth five-year plan.

However, Indian highway construction has hit several severe bottlenecks, and even the admittedly slow rates of the last five years cannot be sustained for much longer if these bottlenecks are not immediately addressed.  

The first is a severe funding crunch that is due to domestic banks reaching sectoral exposure limits and facing asset-liability mismatches.  To alleviate this problem, the Indian government needs to go further on the road of free enterprise and remove restrictions on participation by foreign banks and non-banking financial corporations so that the cash crunch in the Indian construction industry can be overcome.

The second is the problem of delays in highway construction, which are due to delays in project tendering and awarding, delays in land acquisition, dispute resolution, and delays in construction.  The government of the day needs to streamline the process of tender awarding by reducing the number of approvals needed.  In particular, ministerial approvals are open-ended and often end up holding up the project for months.  These can be expedited by creating automatic routes of project approval where ministerial intervention is not required as long as pre-set expectations are met by bidders.

Delays in project execution due to engineering shortcomings can be eliminated by making the Indian construction industry adopt best-in-class practices, such as lean manufacturing and adopting a value engineering mindset.  One of the best ways to make local industry adopt international norms is to actively encourage participation in the Indian infrastructure experience by world-leading construction companies.  Their very presence in Indian projects, and the resulting movement of people between them and local players will ensure that these ideas are widely adopted in India, purely from the standpoint of Indian industry being able to compete with foreign majors.  This also applies to best-in-class procurement techniques, group contracts, supply-chain management, and so on.

Dispute resolution can be resolved by fast-track processes, such as have been suggested by the Chaturvedi committee.

By far, the greatest danger to the present highway expansion program is the recently-passed legislation on land acquisition, the LARR.  This legislation has the potential to completely derail the Indian growth train by making land acquisition costs prohibitively high and by causing huge delays in land acquisition owing to clauses such as the need for a project to be approved by 70-80% of the affected parties.  I am not suggesting here that the voice of the affected parties should not be heard.  They should, but the process needs to be fair to both parties. 

The LARR is a highly one-sided legislation that has been passed purely on populist and not on practical grounds.  Unfortunately, 2013 being the year before a major election, no party really had the courage to oppose the bill on principles of sound economics, lest it be seen as an “anti-people” party.  It takes a really bold political leader to understand and explain that true “anti-people” policies are those that make infrastructure creation impossibly expensive and complicated, and result in everything being more expensive for the “common man” – from loss of goods and perishables due to poor road conditions and long times to market; to more expensive products because of greater transportation costs because fast highways are not available.  This legislation should be amended as soon as possible in favour of a more equitable and balanced legislation that does not compromise the legitimate interests of the affected farmers, slum-dwellers, and other parties affected by highways, but at the same time does not create new roadblocks that interfere with the speed of highway building, which is a critical component in national development.

India also needs to transfer its learnings from the highway sector to improve its road-building processes at the village, town, and city levels.  The main lesson learned has been that the state should move from the role of an all-in-one payer-and-builder to that of only a payer and, if possible, not even that.  What this means is that more intra-town and intra-city projects should be handled on LSTK basis and handled on an EPC basis rather than have the PWD design and construct these roads.  The role of the state should be in formulating the correct vision for the path forward, in setting the right standards to which roads and highways need to be built, and in setting up transparent oversight bodies to oversee the work and make things clear to the paying public.  The rest should be outsourced.  This is the model that has worked for India in its highway sector and is the model that has worked in many other sectors as well, both in India and abroad.

There needs to be greater devolution of powers, to deal with instances such as the one I mentioned early in this article, about the pothole near the apartment complex I lived in Pune. Powers need to devolve from the state to the municipality to the citizen.  In this case, if local citizens feel that a road is inadequate, they must be empowered to get a contractor themselves and repair things on their own.  And, in return, the state should not tax the citizens in advance for repairs that may or may not be performed.  Finances for road repairs should be sanctioned by citizens periodically on a per-case basis, and tax revenues that are charged should be justified before being levied.  That is the essence of true democracy.

Finally, the serious financial crunch that the Indian highway sector finds itself in should give pause to Indian government planners who have been on a welfare binge recently and make them realize that they don’t have unlimited funds to dole out freebies to buy votes.  The huge cost of social programs is hitting India where it hurts it most – in deficient infrastructure that is holding back the progress of the country.  Deficient infrastructure and lack of progress do not discriminate in their impact between the rich and the poor - they affect all sections of people.

Other Articles in The Free-Market Series

Hospitals (coming soon)
Power Generation and Electric Supply (coming soon)
Water Supply (coming soon)
Telecommunications (coming soon)
Railways (coming soon)
Public Transport (coming soon)
Defence (coming soon)
Agriculture and Food Sufficiency (coming soon)
Education (coming soon)
Conclusion (coming soon)

3 comments:

  1. Hi Kumar. Good article; lots of information. Wanted to make a couple of comments.

    The Item Rate contract is used for cost containment as well as 2 other reasons. This is based on my own experience in awarding and managing factory construction projects for my company. One is to delink the contractor's income from prices of main raw materials: cement and steel, which often fluctuate widely. The margins for a construction project relative to the cost of cement and steel are rather thin. Through item rate contracts, cost differences can be adjusted depending on fluctuations in market price.

    Another interesting (for lack of a better word) reason is to prevent cheating. Not only is the contractor paid based on actual bills for cement, but the design firm or the in-house design team of the project owner estimates the amount of cement required for the project based on the civil design, and contractors have to be within +/- 10% of this estimate (verified through material issue slips) or there is a penalty. This is to make sure contractors stick to the design. Apparently if you do not do this, and make it a lumpsum contract, the contractors tend to alter the cement to sand ratio in concrete (use less cement) or cheat on the thickness of the concrete elements, in order to squeeze some extra profit out, and in the process actually endanger the safety and longevity of the civil structure.

    I agree with you that the recent LARR has swung the pendulum the other way and jeopardized all large investments requiring land acquisition. I just wanted to point out some additional info:

    1. The law has 2 separate parts: on acquisition and on relief and rehabilitation. The first deals with acquisition process including obtaining consent and impact assessment, and the second with the compensation.
    2. For govt projects, while consent and impact assessment may not be required, the R&R provisions still apply.
    3. The acquisition provisions apply for private projects only if the pvt company asks the govt to assist in acquisition of the land. They do not apply if the pvt co directly purchases land from the landowners (of course in that case they can get stuck if even one landowner refuses to part with his land). But the R&R provisions still apply, if I recall right, if the total size of acquisition is more than some cutoff (it has been a while since I read through the text of the Act).

    Dhananjay

    ReplyDelete
    Replies
    1. Thanks very much for the kind words and for the useful comment, Dhananjay.

      Thanks for the clarification on item rate contracts. Yes, it helps to separate the contractor's profits from raw material costs, and does help in checking the possibility of cheating. I understand you are talking from your perspective in perspective, where you are honest and want to make sure the contractor is honest. But you also have the flip side in government, where the officer may not be honest, and so item-rate contracts increase the probability of bribery at every stage and in passing every expense.

      Now, I agree with you on the possibility of cheating in lump-sum contracts. That's why my recommended approach is to have a strong external auditor culture. One thing I have learned in India is that the concept of external auditors works really well in India. Look at balance sheets and company audits. Everywhere I have worked and have seen my wife work, people take audits VERY SERIOUSLY. They will not approve even Rs. 5 if you don't have a receipt to prove the expense. Everyone complies.

      So my approach to monitoring quality and reducing cheating is to use external auditors. In the case of roads and other infrastructural projects, I would actually suggest that every step be audited by 2-3 external auditors. The auditors would come from a government-approved list of auditors, who will test the structure, go to the site and conduct suprise checks, and so on, to verify that everything is kosher. Now, you can say that they can bribe the auditors, too, but then you have to counter this in four ways. One is that if there is a single case of an auditor being dishonest, they will be disqualified from auditing any government work for 10 years. So make it a very strong financial incentive for them not to cheat. The second (to enforce the first) is that once in a while, double-check the auditor's job by getting the job checked by a third-party, international auditor at job completion to determine if the job was done right (so they drill and get some core samples to do some scanning, etc., and determine if there has been cheating). The third way is to rotate auditors so that no contractor can have a permanent relationship with an auditor. The fourth is to eliminate administrative entry barriers for auditing firms in India so that there will be a large pool of auditors so that the internal competition among them and the fear of losing their government certification will ensure that they will never collude with the contractor and cheat on the audits.

      If these steps are taken, I think that lumpsum contracts can be used with proper auditing to greatly reduce corruption and maintain standards. We should move to a model where the government stops being both the payer and the auditor. The government should, in a free market system, have ONLY two functions: paying and setting standards. And both, as much as practicable, should be devolved so that if the people wish to themselves pay and audit a particular project that only affects them, they should be free to do so.

      I will reply in a second comment to the LARR comments.

      Delete
    2. Dhananjay:

      On LARR, I believe I have mentioned that consent is not required for Government projects. See point 3 of my description of the LARR. So for government land acquisition and PSUs, consent provisions do not apply.

      On your point 3, you are absolutely correct. Thanks for adding that for the benefit of all readers. It is an important thing to mention - that even for entirely private dealings, the government has regulated what you can do. This is dangerous for all large business activities. And, as you say, the R&R provisions apply for all acquisitions above a certain area, which is not specified, but left to the discretion of the local governments. This will greatly increase the cost of doing business.

      Delete