The States Show The Way

Sometime next month, when the 760 km long rail network runs its first train through the Konkan region, there will be more than just national pride at stake. The network which is expected to cost close to Rs 3,000 crore and has been more than four years in the making is also a landmark effort in infrastructure financing. It has shown that large infrastructure projects can be handled without direct sovereign involvement and the trick is leveraging state participation for raising public resources.

The Konkan Railway Corporation, has had to work with four states that the rail track covers: Goa, Maharashtra, Karnataka and Kerala. And since private participation in the form of equity was deliberately kept out and direct government help was not forthcoming, the corporation had to explore new avenues. The fact that it has been able to do so with debt equity ratio of 2.5:1 (in comparison, the Channel Tunnel between the UK and France, an equally large infrastructure project, has already hit a debt equity ratio of 9:1) has several lessons in project finance. Here is a close look at how the deal was sewn up.

 

Konkan Railway is a project with 51 per cent equity from the ministry of railways and the remaining 49 per cent is being contributed by the four states of Goa, Maharashtra, Karnataka and Kerala. It was floated on the build operate and transfer (BoT) model. This model was adopted in view of the large capital expenditure that the railways were expected to undertake for, rolling stock, project uniguage, line electrification and switch over from manual signalling to electronic signalling systems.

Only a part of the funds for such projects could actually have come from internal resources mostly revenue surpluses and the depreciation reserve fund. The rest of the funds would have to be sourced from the general funds, which is from the government. Internal resources are mainly required to meet maintenance costs of permanent ways, rolling stock and for new projects. These comprise the depreciation reserve fund (DRF), development funds and capital funds. Of this, the DRF alone contributes over 60 per cent of Indian Railways internal resources. DRF is accumulated through appropriations from the earnings. The accounting of this fund is rather different from conventional depreciation accounting. It follows neither the straight line method nor the written down value method followed in conventional accounting. Instead, the Rail convention committee periodically makes recommendations as to how much should be set aside for depreciation based on the replacement cost value of the assets of both rolling stocks and permanent way equipment. The development fund again is an appropriation. Capital fund and the development fund are appropriations from the surplus after payment of dividends to the government.

However, funds from the depreciation reserve fund cannot be used for funding new projects. These would have to come from the general funds. And contribution to the general funds has been declining consistently, as the railways have been pushed to raising extra budgetary resources. And this is one of the problems that the Konkan Railway Corporation was first up against it had to look for extra budgetary resources and hence hit upon the BoT model.

But Konkan Railway is actually a refined model of the Build operate and Transfer (BOT) platform. Any conventional BOT model has an element for private equity ownership. But railways have so far not factored in the private sector ownership of the Railways. Therefore, accordingly there is so far no system of private participation in the equity of the project. The only private participation in the project comes in the form of debt, which has been mostly in the nature of tax-free bonds. The Konkan Railway, till 1995-96, has raised close to Rs 1,414 crore through this route, which works to a debt equity ratio of close to 2.5:1, which is quite remarkable, since a project of equivalent risks and costs, the Channel Tunnel project between Britain and France has already hit a ratio of 9:1.($ 9 billion in debt and $ one billion equity).

The KRC task was made that much more difficult because private participation has been kept out deliberately. This is partly because the railways would prefer to maintain the public ownership status of this project. The main reason however is, that private participation would have meant meeting just minimum return expectations after a specified gestation period, in the form of a minimum dividend when revenue generations begin and capital gains accrue at the time of transfer of the project back to the railways. At the time of conception of the project, the financial feasibility was not very clear.

This feasibility depends on the traffic movement on the lines. Since in such projects the element of operational finance risk tends to be high, BoT operators follow a system where they get into pay or take contracts, where there is assured minimum revenues to the projects. And offering a minimum rate of return on the project would have meant that the final costs of the project would be more than estimated. The project is already facing cost escalations, which is not unusual for projects of this magnitude. Eurotunnel for instance was almost five years behind schedule.

At the same time, the revenues from the project, through rentals from traffic movements have been estimated very conservatively. Profit before interest, but after depreciation, is expected only some time in 2005, based on a revenue estimate of Rs 364 crore per year. After interest payments, there is no expectation of profits. Besides, each escalation is bound to lead to continuing losses, exactly like the euro tunnel. Eurotunnel for instance has been able to generate revenues of just $480 million each year, considerably short of expectations leading to severe operational losses. The Konkan Railway however may not face such operating risks as in the case of the eurotunnel.

This is because of an expected minimum revenue inflow from committed rail traffic on this corridor. However, the minimum revenue expectations made by Konkan Railway is unlikely to be sufficient to meet the financing of project escalations. This is in view of the delayed commissioning of the corridor, and this delays revenue inflows. Such cost escalations are currently being financed through debts and through tax free bonds with front end discounts. These discounts would appear as deferred revenue expenditure at maturity and have not been factored into the original capital costs. The last series of bonds Konkan had offered in the markets on a private placement basis had offered a front end discount of 5 per cent, resulting in an effective post tax yield of about 14 per cent. This in turn could lead to a severe cost escalation. Yet despite this cost of 14 per cent, Konkan Railways managed to get the funds cheap in a tight market. This was facilitated by the state ownership in the project. Private sector involvement would have lead to higher interest costs.

It is quite possible however, that the traffic revenue could exceed the estimates. Senior Railway officials say, If our estimates are exceeded then the equity participants may be able to receive dividends on their investments. And this dividend or the assurance of a dividend on the enhanced traffic would be necessary if debtors are expected to convert their existing bond holding into equity for the project. Since a large quantum of the debt, about 65 per cent is held by financial institutions and banks, conversion into equity would be possible only if there is an assured returns by way of dividend.

The biggest impact of this kind of project conversion is bound to be on the states finances and states taking the initiative to funding projects across their own borders. Even a 10 per cent dividend declaration by Konkan could result in a non-tax revenue inflow of Rs 3.6 crore into Kerala, 9 crore into Karnataka and Rs 13 crore into Maharashtra. Shedding the states equity at a 10 per cent premium to face value for the investors would then mean a rate of return on this investment of four per cent in 2006, which is more than what the states would get from their electricity board or their public sector undertakings through direct investments.

In addition to the four per cent return on investments, the actual returns generated could actually turn out to be much higher, if the indirect tax realisations based on existing tax rates are included. Obviously, this has been the best model, where all the investors have benefitted without compromising on state involvement in large scale projects and could also be a precursor for other mega buck projects in core infrastructure.

The KRCs task was made more difficult because

private participation has been kept out deliberately. This is partly because the railways would prefer to maintain the public

ownership status of this project