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Developing highways -- Why so many twists in annuity method?

P. Manoj

THE much-publicised annuity method to have highways constructed with private participation has come in for sharp criticism from various quarters. Not without reason though. The criticism might appear justified, particularly against the backdrop of the En ron experience in the power sector. After all, the annuity method, if adopted for construction of highways, will, it is pointed out, entail a drain on the country's road building resources despite the Government taking the major risks relating to traffic .

What has been perceived as a golden goose for the private sector may turn out to be a nightmare if the operator fails to meet the stipulations. The highway projects have to be completed in time and operated and maintained to certain specified standards. In other words, the annuity payout is linked to strict standard specifications laid down by the National Highways Authority of India (NHAI) which is taking on the traffic risks but transferred other risks to the private firm that is to be involved in the project.

Isn't this, then, a win-win for the NHAI? Not necessarily. As the critics will argue, the method is costly and the Government should undertake the projects on its own in the conventional way, especially when it is already assuming the traffic risks. A li ttle bit of analysis might help.

Under the annuity method, a private entrepreneur will construct, operate and maintain a road project in accordance with specified standards. As, unlike as in the direct tolling system, he will not collect a toll from the users, it is considered traffic n eutral. He, however, will be paid a semi-annual sum by the NHAI to cover the capital costs, operating expenses and returns thereon.

Thus, the NHAI is assuming the major risk relating to traffic under the annuity approach. What, then, are the `other risks' that which are proposed to be transferred to the private sector?

These are risks which arise under both during the construction and operation phases. The construction period risks include design risk, that is, risk involving rework based on revised designs, additional work, loss of durability and serviceability and ri sks relating to price escalation on labour, general material, POL, plant and machinery, bitumen, cement, steel and foreign inputs, quantity variation, time overruns, quality risk, failure of contractor/abandonment of project, force majeure risks comprisi ng both non-political and other events. The operations period risks include funding risk, cost increases, quality risk, non-availability of service and user safety.

The escalation in the construction cost is an integral part of every project procured through the conventional approach. The risk arising out of variation in quantities under different items of work to be executed is fully borne by the private operator u nder the annuity method, whereas under the conventional method, this risk is retained by the employer, in this case the NHAI.

The risk in time overruns -- that is, delay in completion leading to escalation in costs and non-availability of services is borne by the private operator under the annuity method. Besides, the annuity approach has an in-built incentive f or delivering quality. Lower than expected asset quality would lead to higher/earlier maintenance costs and non-availability with resultant financial implications for the private operator.

Substantial cost and time overruns of the project on account of contractor failure/abandonment of project is fully transferred to the private sector under the annuity method. Non-political force majeure events, such as terrorism, strikes, boycotts, and s o on, are transferred to the private entrepreneur while events due to war, ionising radiation, volcanic eruption, rebellion, riots, etc., are shared between the NHAI and the private operator under the annuity method.

Suffice it to say that the NHAI is not required to pay anything to the private operator during the construction period. The payment obligation of the NHAI begins only six months after the commissioning of the road facility.

Any delay beyond the scheduled commissioning date would lead to a pro-rata reduction in the annuity in that annuity payment period. It is pertinent to note that a study of 17 highway projects developed with multilateral assistance exhibits cost overruns ranging from a minimum of 18 per cent to a maximum of 247 per cent. The average level of cost overrun is around 104 per cent on the original estimates and 60 per cent on the revised figures, according to figures worked out by the Department of Programme Implementation.

The risks arising during the operations period including funds for maintaining the road, cost increases on maintenance, quality of road service, non-availability of service and user safety are transferred to the private sector under the annuity method, w hereas all these are retained by the NHAI under the conventional method.

And, significantly, annuity is a fixed sum which remains constant throughout the concession period and is not linked to any index, namely, inflation, POL prices, forex rates, bitumen prices, etc. Thus, the entire risk of completion plus the business risk during the operations phase have been transferred to the private sector while the NHAI assumes only the traffic risks and political force majeure risks. The non-insurable force majeure events are shared by NHAI and the concessionaire.

Another important point to be noted here is that the NHAI has decided to toll the highway stretches developed through the annuity method either by itself or by appointing private tolling contractors. Thus, under the annuity approach, the NHAI would get a revenue generating asset with a deferred payment obligation with the entire risk of completion and service quality being borne by the private sector.Under the conventional approach, the NHAI's investment would not only be front-loaded but the entire com pletion risk and the responsibility for service would also have to be borne by the NHAI. Value for money considerations require that the decision makers need to make realistic assumptions regarding costs NHAI would incur under the conventional approach, the impact of quantified risks under the conventional approach, juxtapose the non-quantified risks that are sought to be transferred to the private sector under the annuity approach and decide whether the annuity quote of the lowest bidder offers value f or money for the NHAI.