Sunil Jain: Cost-plus killers

RATIONAL EXPECTATIONS

It is pretty apparent by now that the government has accepted the cost-plus pricing model, with a regulator, and bidding on revenue-share as the perfect one for the plethora of public-private-partnerships that are expected to come up in the coming months and years to develop infrastructure in the country.

Cost-plus is considered important because this ensures there will be enough entrepreneurs, as there wouldn't be too many takers for infrastructure projects, which have huge implementation as well as demand risks""it's a different matter that "contractors" seems a more appropriate word to describe entrepreneurs who don't want to take risks. The regulator is important in the model because it is this institution that ensures companies don't pad up their costs in order to get higher returns. And the fact that companies bid for the project, on the share of the revenue they will share with the government, supposedly brings in the element of competition, and ensures the government doesn't play favourites in awarding the contract. Above all, it ensures the government continues to get some benefits from the development and, since more often than not, privatisation results in higher revenue coming from the privatised entity (such as the Delhi and Mumbai airports), the net impact can be quite significant.

Even if you leave aside the many cases of the government trying to interfere in the regulatory process, the larger problem is that the model just cannot work, and that is why the political-bureaucratic-regulatory class finds it easy to keep stepping in, to come up with patchwork solutions, which are then justified by arguing that the model would have collapsed if this was not done"" isn't it better to give the Nhava Sheva International Container Terminal (NSICT), by way of example, some extra money than to see the entire container operations in the port come to a complete standstill, and so on. It's an argument that has some appeal, especially in the short run, but if the model is what is causing the problem it is time to revisit the model.

For one, while the latest policies say that the revenue share can no longer be expensed by the company and so cannot be charged to the consumer (this was allowed earlier and it jacked up consumer costs), this is simply not possible. Take the case of a firm that invests Rs 500 crore in a project, and has operating expenses of, say, another Rs 150 crore. Under the cost-plus regime, the tariffs will have to be set in such a way so as to cover this Rs 150 crore and another Rs 75 crore (that's a 15 per cent return on the capital employed of Rs 500 crore), which adds up to Rs 225 crore. Now if the tariffs are set in such a way as to give the firm a revenue stream of just Rs 225 crore, it clearly cannot afford to part with any portion of this. But in a revenue-share arrangement, it just has to.

In which case, the firm has a finite number of options. It can pad up costs to as to get a higher revenue stream and then pay the revenue share comfortably; two, it can be honest, not pad costs, share its revenue with the government and simply go under; or, three, it can argue that the model is not sustainable and hope to get a sympathetic audience. By the way, this is not just a theoretical construct but applies to real-life situations. I've looked up the annual revenue statements of several container terminals on the website of the Tariff Authority on Major Ports (www.tariffauthority.gov.in) and, sure enough, the model collapses once you factor in the revenue shares the firms have to pay the authorities over the years. The model appears to work in the case of the NSICT since the accounts show a surplus even after you deduct the royalty payments from the surplus after accounting for the operating costs and cost of servicing capital""but the reason why this is so is, as TAMP pointed out in one of its orders, the NSICT was charging much higher tariffs than it should have been (this happened because the original tariffs assumed a cargo traffic that was 60 per cent lower than the actual).

There is a fourth option, but it applies only in special circumstances as in, say, the airport bids that were awarded in Delhi and Mumbai. In the Delhi and Mumbai bids, the operator will also lose money in the revenue-share model, but the reason why this is still sustainable is that the airports have a city-side development (shops, restaurants, hotels, and so on) where the tariffs are not regulated on the basis of costs""so, what the company loses on the regulated airport operations, it can hope to make up in the city-side. In the case of ports and roads, where a host of such bids are coming in, there is no city-side revenue model which comes along as part of the package.

If the government is serious about developing infrastructure using private sector firms, it needs to move to a model that works. That involves getting firms to bid on prices and taking the risk of the projections going wrong. Becoming genuine entrepreneurs if you will.