Cost of annuity projects: A new risk has emerged in govt's financials

This favoured route for financing roads is gaining traction for other infrastructure projects but could result in unsustainable liabilities for the government

As the push for infrastructure projects becomes the new mantra in government business, a new risk has emerged in the financial statements. It is the cost of annuity projects.

At Rs 38,775 crore as of March 2021 this item has seen the largest jump in the list of government liabilities. This is in addition to the Rs 3,46,343.8 crore of total outstanding guarantees on the government books as of March 2021. In just one year, Finance Minister Nirmala Sitharaman has added 11 per cent to total liabilities from these annuity projects.

The dominant presence of annuities has a simple reason. Contractors were often reluctant to bid for the government’s infrastructure projects, primarily because the payment flow from these was often uncertain. In roads, for instance, the National Highways Authority of India (NHAI) sometimes offered bids on exaggerated traffic projections, or the hassles of acquiring land pushed the project deadline.

The annuity model — or the hybrid annuity model, to give it its full name — circumvents these risks. In the design of these projects, the government has promised to pay 40 per cent of the project cost in the first five years through annual payments. The remaining payment is made on the basis of the assets created and the performance of the developer — the construction and maintenance standards — remain with the private parties. The pattern of the fixed payouts by the government, much like the insurance policies that offer similar timely benefits, gives rise to the term annuity. Since the government also retains the right to change the payouts later depending on the performance, these transactions are called hybrid annuity models.

For the road developer, the incentives are obvious. Based on the committed 40 per cent payout by the government during the construction phase, the dev­eloper can raise the re­m­aining 60 per cent as equity or loans. Banks, which are often reluctant to finance long-term infrastructure projects, are happy to fin­a­nce these projects because of the lower risk. The political risks of a privately built road also come down. In exc­hange for the committed financing, the builder foregoes the right to levy toll. The public is reassured that revenue collection is the NHAI’s responsibility, not that of a private company, which created many problems in the past. The reason for the burst of road construction is a testament to the success of this hybrid annuity model. From 2,623 km built in FY17, the pace jumped to 4,175 km in FY21.

But such a seemingly win-win scenario has costs and those are rising. As the pace of infrastructure project construction in the economy will expand, the liabilities of the government departments will rise concomitantly. The largest contributor to the pool is the Ministry of Road Transport and Highways, but others are testing the waters, such as the Jal Shakti ministry (see table). When this model was constructed, it was expected it will be offered only after the alternatives such as build operate and transfer (BoT) modes were explored and found unviable. A chat with project managers at banks shows that annuity models have become the default choice instead.

The risks remain under control so long as the bidding-out agencies such as the NHAI are able to finance the new road projects from the collections from those already built and in operation. In other words, they have to keep monetising the older stretches to finance the new ones. But this is not happening, as of now. The reasons are again simple. Most of the roads being built in India are new. A Crisil report shows half of them are less than five years old.

The average revenue from each of these projects is about Rs 46,00,000 per km, as of fiscal 2020. That figure will improve as traffic builds up reaching a breakeven level of Rs 1 crore per km. Like most infrastructure assets, incomes from roads take time to settle into a yearly pattern. But the large nursery of young assets, which cannot be monetised, creates a short-term mismatch for the NHAI. The authority’s leverage had risen to 1:5 by November last year. And the numbers are big. In a written reply in Parliament, the minister for road transport and highways, Nitin Gadkari, has said the NHAI has run up a debt of Rs 3.38 trillion by the end of December 2021.

This pace will rise further to keep up the target of the National Infrastructure Pipeline. Lead author of the Crisil Research report Isha Chaudhary estimates the NHAI’s fund requirements could double to Rs 10 trillion over the next five years over the previous five years.

Consequently, the finance ministry has had to step in. It has stopped the NHAI from borrowing from the markets. Sitharaman has instead committed to provide Rs 65,000 crore to Gadkari in FY23. And the liability of Rs 38,775 crore from 40 such annuity projects has been placed as direct government liability. It is salutary in the sense that an off-budget liability has been made explicit but for financing the infrastructure burst these have implications.

The large number of these entries shows that it was proving impossible for the NHAI to finance construction as annuity projects. Going forward, the NHAI is expected to be more circumspect in signing on to fresh annuity projects. Whether road developers will retain their enthusiasm to bid for new projects in the new circumstances is a question rating agencies and banks will watch closely. If, on the other hand, one goes by the ambitious target set by the finance minister to tender 25,000 km of roads in the next financial year, one has to assume that the annuity liability on the books of the government will escalate rapidly.

It is true that as the older roads mature in traffic profiles, some of the payouts from them could leave the government books, but the expanding pace of construction means the new entrants will be far larger.

That new ministries like Jal Shakti are also warming up to the prospects is cause for alarm. The government needs to reconsider if the recovering growth rate of the economy should be the reason to wean the projects from this spoon-feeding.