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Edited byHarinder Kohli, Ashoka Mody,and Michael Walton

The World BankWashington, D.C.

Choices for Efficient

Private Infrastructure

Provision in East Asia

1 Making the Next Big Leap: Systemic Reform for Private Infrastructure in East Asia 1Harinder Kohli, Ashoka Mody, and Michael Walton

2 Organizing the Government for EfÞcient Private Participation in Infrastructure:Lessons from Australia 21Donald Russell

3 Contracting for Private Provision of Infrastructure: The Malaysian Experience 43Yahya Yaacob and G. Naidu

4 Regulating Private Involvement in Infrastructure: The Chilean Experience 55Alejandro Jadresic

5 Managing Environmental and Resettlement Risks and Opportunitiesin East Asian Infrastructure 71Bradford S. Gentry

6 Financing Private Infrastructure: Lessons from India 81Montek S. Ahluwalia

iii

Contents

Much is expected of private Þnancing tohelp meet the infrastructure require-ments of the rapidly growing East

Asian economies. In the Þrst half of the 1990sprivate Þnancing did grow briskly. East Asia ledthe developing world in total internationalÞnance for infrastructure, and a sharply grow-ing share of that Þnance went to private projects(Þgures 1.1 and 1.2). In 1996, $13 billion in inter-national capital ßowed to East Asian infrastruc-ture projects, more than $9 billion of it forprivate activities. Domestic sources provided anestimated $3 billion for private infrastructure.

Despite the growth in private investment, itremains a small share of all infrastructure invest-ment in East Asia, between 12 and 18 percent(although there is much variation in this shareacross the region). And because much of thisinvestment is backed by implicit or explicit gov-ernment assurances, the share of private capitalat risk is far smaller. Moreover, the growth of pri-vate Þnancing slowed in 1996, partly because ofthe lumpiness typical of infrastructure invest-ments. This monograph draws on experience ina number of countriesÑin East Asia and else-whereÑto analyze the impediments to andprospects for private Þnancing of infrastructure.

The challenges in achieving substantial pri-vate risk-taking are many. Most East Asianeconomies have adopted an incrementalapproach to private participation in infrastruc-ture. They have sought private investmentmainly for speciÞc projects, ring-fenced to insu-late them from the existing structure of delivery.The result has been variable ßows of investment,typically backed by substantial government

support. Recognizing the limits to privateinvolvement under the incremental approach,some countries are undertaking broader policyand institutional reforms aimed at creating anenvironment more conducive to private partici-pation, but these efforts are still at an early stage.Designing such reforms, improving methods ofcontracting with private parties, building regu-latory capacity, and developing domestic capitalmarkets remain on the policy agenda in all theregionÕs economies.

The chapters in this monograph illustrate thepolicy concerns and choices in moving towardefÞcient private involvement in infrastructure.Choices arise in the strategy and organization ofreformÑwith regard to sector, the extent of pri-vate participation, the speed of reform, and theplanning and coordinating roles of the govern-ment. Choices must also be made in the meth-ods for contracting and regulation, themanagement of environmental and resettlementissues, and the development of Þnancing mech-anisms to increase access to long-term funds.The chapters draw on experience in a range ofcountriesÑAustralia, Chile, and India as well aseconomies in East AsiaÑto show what choicesare available and what strategies governmentshave followed. Experiences from outside EastAsia illustrate the payoffs of a more integratedand concerted move toward private provision ofinfrastructure.

The chapters were originally prepared asbackground papers for a high-level conferenceon private involvement in infrastructure, spon-sored by the World Bank and the government ofIndonesia and held in Jakarta, Indonesia, in

1

Harinder Kohli, Ashoka Mody, and Michael Walton

1 Making the Next Big Leap:Systemic Reform for PrivateInfrastructure in East Asia

September 1996. Ministers from East Asian gov-ernments and senior private sector representa-tives gathered for two days to identify anddiscuss the major stumbling blocks to broaderand more effective private participation in infra-structure.

This overview chapter describes the recenttrends in international Þnancing of infrastruc-ture projects in East Asia, discusses the key pol-icy and institutional impediments to greaterprivate participation, and assesses the role ofdomestic capital markets and Þnance. It then out-lines a national and regional strategy for stimu-lating private investment in infrastructure.

Trends in international Þnancing forinfrastructure

East AsiaÕs appetite for infrastructure Þnance isevident in the numbers.1 In 1996 East Asianeconomies received $12.7 billion for infrastruc-ture through equity, loan syndications, andbond issues, absorbing just under half of the$27.4 billion in infrastructure Þnance receivedby all developing countries.2 Three-quarters ofthe international ßows to East AsiaÑ$9.3 bil-lionÑwent to private projects. In the rest of thedeveloping world too the private sectorÕs sharein international capital ßows for infrastructureincreased steadily over the 1990s, from about athird in 1991 to three-quarters in 1996 ($11 bil-

lion). Indeed, in 1996 the ßows to public projectsfell sharply, from about $5 billion to just over $3billion.

A distinguishing feature of private capitalßows to East Asia is the large share going to newprojects rather than to Þnance the transfer ofassets in privatizations. Between 1984 and 1996the number of privatization transactions in LatinAmerica was about the same as the number ofnew investment transactions; in East Asia, bycontrast, there were only a third as many priva-tization transactions as new investment transac-tions (World Bank, Private Sector DevelopmentDepartment, Private Infrastructure ProjectDatabase). Privatization drew 20 percent of theÞnancial ßows for infrastructure into East Asiain 1993, 35 percent in 1994, and less than 10 per-cent ($800 million of $8.7 billion) in 1995 (WorldBank, International Economics Department,Privatization Database).

Who is receiving the investment?

No single country in East Asia has dominated ininternational Þnance for private infrastructureprojects. In 1995 and 1996 Indonesia was thelargest recipient, however, receiving almost $4billion in each of these yearsÑ40 percent of allßows to private infrastructure projects in theregion (table 1.1). Private capital for infrastruc-ture accounted for about a third of all private

Figure 2 . . . and devotes a growing share of it to private projectsInternational infrastructure financing raised in East Asia, by type of borrower, 1986–96 (US$ millions)

0

2,000

4,000

6,000

8,000

10,000

199619941992199019881986Source: World Bank 1997a.

Private

Public

2 Choices for EfÞcient Private Infrastructure Provision in East Asia

Figure 1 East Asia leads the developing world in international finance for infrastructure . . .Infrastructure financing raised by developing countries, 1986–96 (US$ millions)

0

3,000

6,000

9,000

12,000

15,000

199619941992199019881986Source: World Bank 1997a.

East Asia and the PacificLatin America and the CaribbeanEurope and Central AsiaSouth AsiaMiddle East and North AfricaSub-Saharan Africa

ßows into Indonesia in 1995 and a fourth in 1996.Before 1995, however, the largest annual capitalinßow for private infrastructure into Indonesiawas $339 million, in 1992. The huge jump in 1995and 1996 reßects primarily the Þnancing of a fewlarge independent power projects whose nego-tiations, under way for many years, had Þnallybeen completed. In addition, the partial privati-zation of the telecommunications authoritydrew in equity ßows, and the award of telecom-munications concessions at about the same timecreated demand for Þnancing to meet the invest-ment obligations under the contracts.

Nor does any other economy in East Asiashow a clear, strong trend (Þgure 1.3). Perhapsthe most consistent growth has been in thePhilippines, however. From virtually none in1991, private investment in infrastructure in thePhilippines grew rapidly until 1995, when inter-national capital ßows for infrastructure werejust over $2 billion. But in 1996 the ßows fell to$1 billion. The fast growth was due to the privatepower program for installation of more than3,000 megawatts of power. Now that the pro-gramÕs objectives have been substantially met,the investments in private power generation aretapering off. But demand for private infrastruc-ture Þnance in the Philippines has been sus-tained by deregulation in telecommunicationsallowing entry by new providers.

Other countries show a choppy pattern. InMalaysia international ßows rose from a smallamount in 1991 to $3.7 billion in 1994, thendeclined in 1995 and 1996. Thailand had a peakinßow of $3.6 billion in 1993 but has had muchsmaller ßows since then. But both countries, par-ticularly Malaysia, have had signiÞcant domes-tic Þnancing.

China may be the dominant user of interna-tional capital ßows for infrastructure in the com-ing years. Inßows into China jumped to $900million in 1996 with increasing activity in powerand transport. Although private investment ininfrastructure remains well below projections,both the government and the private sector havetaken actions likely to boost it. The governmenthas prepared a model for build-operate-transferprojects and applied it to the Laiban power pro-ject. The private sector has recently raised fundsby securitizing existing projects and then issuingshares on the Hong Kong (China) and Shenzhenstock exchanges. This Þnancing strategy marksa shift from pure project ÞnanceÑwhere Þnanc-ing is based only on project cash ßows and rev-enuesÑto a corporate Þnance, or pooled,structure, which generally gives greater comfortto lenders.

Making the Next Big Leap: Systematic Reform for Private Infrastructure in East Asia 3

Table 1.1 International finance for private infrastructure in selected East Asian economies, 1986–96

Country 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

China 0 0 0 0 0 0 761 145 212 185 904Indonesia 0 0 34 0 0 0 339 0 161 3,690 3,809Korea, Rep. of 75 160 12 0 957 285 330 105 374 772 1,164Lao PDR 0 0 0 0 0 0 0 0 0 0 20Macao 0 0 0 0 0 0 0 0 246 0 0Malaysia 10 0 42 767 266 31 240 1,135 3,714 1,074 703Philippines 0 0 0 0 23 39 336 707 1,044 2,135 1,072Thailand 0 0 0 0 291 0 20 3,619 1,015 936 1,622Vietnam 0 0 0 0 0 0 0 0 0 5 12Total 85 160 88 767 1,537 355 2,026 5,711 6,766 8,797 9,306

Source: Euromoney; Loanware; Bondware; World Bank staff estimates.

Figure 3 International financial flows to private infrastructure as a percentage of GDP, 1986–96Percent

0

1

2

3

4

5

6

199619941992199019881986

Source: World Bank 1997a and 1997b.

MalaysiaPhilippinesIndonesiaThailandKorea, Rep. ofChina

Sectoral shifts

The capital ßows for private infrastructure inEast Asia have clearly been driven by indepen-dent power generation and telecommunications.While in Latin America telecommunications hastaken a decisive lead, in East Asia neither sectorhas dominated. Power took the lead in 1992, butwas overtaken by telecommunications after asubstantial investment in Thailand in 1993, andsince then the two sectors have traded the lead afew times.

Despite some privatization of telecommuni-cations in East Asia, a substantial share of theßows into the sector has come through build-operate-transfer schemes (in Indonesia andThailand) that give private operators responsi-bilities in a geographic area for a Þxed period.The investment commitments for these projectsrequire ÒlumpyÓ Þnancing. By contrast, much ofthe ßow into Latin America has come throughprivatization of state-owned assets, followed bysteady growth in new investments. Both regionshave received relatively low levels of Þnancingfor transportation projects in recent yearsÑnotsurprising given the problems faced by manysuch projects. But international Þnance statisticsunderestimate transportation investment inEast Asia, since domestic capital markets, espe-cially in Malaysia and Thailand, have beenactive in Þnancing transport activities.

The changing instruments

The mix of Þnancing instruments in East Asia dif-fers from that in Latin America, reßecting the dif-ferences in the sectoral pattern of demand forÞnancing. Following the privatization of assets,Latin American infrastructure enterprises haveturned to bond and equity markets for most oftheir international Þnancing. In East Asia therehas been a signiÞcant rise in international bondand equity Þnance, but syndicated loans havebeen the main source of Þnance, accounting formore than half in 1996 and an even larger sharein 1995 (Þgure 1.4). This is explained largely byprivate power projects, which have relied mostlyon syndicated loans, with debt-to-equity ratios inthe range of 75 to 25. In East Asia telecommuni-cations Þnancing, like Þnancing for privatepower, has followed the limited recourse model(in which repayments are based largely on theprojectÕs ability to reÞnance the debt). Thetelecommunications sector has relied more onbond and equity issues than has the power sector,but syndicated loans have also been important.

Policies and institutions for privateinfrastructure

The review of international Þnance for privateinfrastructure in East Asia shows that the ßowsare signiÞcant relative both to public ßows andto ßows to other regions.3 But investment hasbeen low relative to expectations. There has beenmuch activity in signing memoranda of under-standing and even in signing actual contracts: inmid-1996 some $120 billion worth of projectswere reported as past the contract award stage.But the recent history of long development peri-ods and high attrition rates for projects suggeststhat many now under discussion could unravelbefore Þnancial closure. World Bank estimates ofinvestment requirements in infrastructure forthe next decade are $1.2Ð$1.5 trillion (Kohli1995). With international Þnance for private pro-jects totaling some $9 billion a year in 1995 and1996 and domestic Þnance playing a modest rolein most countries, a Þllip is clearly needed toensure the infrastructure expansion critical tosustaining East AsiaÕs development in the nextcentury (box 1.1).


Figure 4 Loans have been the main source of international finance for private infrastructure in East AsiaPercent

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

8,000

199619941992199019881986

Source: World Bank 1997a.

Loans

Bonds

Equity

Is the slow progress in private investment ininfrastructure a sign of intrinsic problems withprivate involvement? Is there, for example, a limiton the availability of long-term Þnancing?Participants at the Jakarta conference tended tosuggest not. The key constraints lie in the frame-work for private provision of infrastructure. It isthe resulting lack of bankable, low-risk projects,not the lack of Þnance, that is at the heart of thepresent predicament. But this is not to deny theimportance of increasing long-term ÞnanceÑandof developing weak domestic capital markets inmost East Asian economies.

What is the target?

Although the share of private investment in EastAsian infrastructure is between 12 and 18 per-cent, this overall Þgure is pulled down by thelow private share in China. The high level of pri-vate involvement in some East Asian economiessuggests that the prospects for private partici-pation are much greater than current levels inmost of the region.

Hong Kong (China) has traditionally hadconsiderable private involvement in all sectorsexcept water (Kwong 1997). Much private pro-vision has also occurred in Malaysia, wherepower, transport, water, and telecommunica-tions have all had some infusion of private cap-ital (Naidu and Lee 1997). It is difÞcult todetermine the extent of private investment inMalaysia because the government has contin-ued to have a signiÞcant Þnancial commitmenteven in ÒprivateÓ projects through equity in pri-vatized enterprises and through grants of landrights, direct subsidies, and concessional loans.But it is likely that the private share is more thanhalf.

Private involvement is also high in thePhilippines, where World Bank estimates sug-gest that about 40 percent of new investment ininfrastructure has been Þnanced through pri-vate projects (Mikesall 1997). Much of the invest-ment in private power projects has beneÞtedfrom government backing of the payment oblig-ations of the National Power Corporation (box1.2). The recent spurt of private investment inIndonesia probably places it at the same level asthe Philippines. The Indonesian government has

refused to provide guarantees, but its ÒcomfortlettersÓ have been viewed by the market asassurances that obligations will be honored.

Elsewhere in East Asia private investment ininfrastructure has been limited. But mosteconomies are gearing up for greater privateparticipation. China has made progress in thepower generation sector with the introductionof model contracts for the Laiban power project.It has recently had success too with poolingexisting power projects to attract Þxed incomeinvestors, using the proceeds for new projectdevelopment. Pooling structures are also beingused for toll road projects (see the section belowon Þnancing mechanisms). The Republic of


Box 1.1 Why expanding infrastructure services inEast Asia is critical to its future

A continued push to develop infrastructure services in EastAsia is crucial to its development as it enters the 21st cen-tury. Why?

• Growth. Demand for modern infrastructure growsat least as fast as the overall economy—and formany sectors significantly faster. Failure to meetthis demand could undercut the potential rapidgrowth. If investment is not boosted in China’sincreasingly congested transport system, forexample, the economy’s growth will be chokedoff. The government of the Republic of Korea esti-mates that infrastructure shortages resulted in aGDP some 16 percent short of its potential in themid-1990s.

• Competitiveness. Good power, transport, andtelecommunications services are necessary in richand poor economies alike to sustain growth andcompetitiveness in an increasingly integratedworld. In Indonesia industrial firms that use captivepower pay more than twice the price of powerfrom the grid.

• Quality of life. Poor infrastructure services mean apoor quality of life despite rapidly rising incomes—especially in urban areas. In many countries house-holds’ access to services remains far lower thanwould be predicted on the basis of income levels.Poor households that have to buy water from ven-dors pay some sixty times the price of piped waterin Bandung and almost twenty times the price inManila and Ho Chi Minh City. Congestion in citiesfrom Bangkok to Shanghai adds hours to people’sdaily commute, in air quality conditions way belowWorld Health Organization standards.

Source:

Korea has historically had little private involve-ment in infrastructure. But it recently raised itstarget for private Þnancing of infrastructurerequirements, aiming for a 40 percent share by2001Ð02, up from the original target of 10percent.

But experience outside East Asia (and inMalaysia and Hong Kong, China) shows thatmuch higher shares of private infrastructureinvestment are possible. The most striking shiftstoward private investment have occurred inArgentina and Hungary, where about 70 percentof infrastructure investment is private. In Chilethe private sectorÕs share in infrastructureinvestment is about half (Mikesell 1997).

The Chilean experience offers a contrast tothe East Asian strategy (see chapter 4). In Chilethe energy and telecommunications sectors arenow almost fully private, there is growing pri-vate involvement in transport, and a major pri-vatization of water is planned. What has ChileÕsstrategy been? Rather than experiment withways to attract investment to speciÞc projects inpower and telecommunications, it has focusedon creating market structures and regulatoryinstitutions conducive to private entry. Theresult: privatized sectors are seeing rapid invest-ment, face no Þnancing constraints, and receiveno explicit or implicit public sector support.Chile has grown 7 percent a year for a decadeand, like most East Asian economies, facesrapidly expanding demand for infrastructureservices. Of a total projected infrastructureinvestment of $18 billion over the next six years,some $13 billionÑ72 percentÑis expected tocome from the private sector.

In East Asia the scale of private sectorinvolvement in infrastructure will depend onsocietal preferences and on institutional and pol-icy conditions. Major infrastructure segments,such as feeder roads, will probably continue to bepublicly Þnanced, and in most of the regionÕseconomies well over half of spending in the nextdecade will be public. Traditional concerns aboutimproving the efÞciency of public sector invest-ment programs and infrastructure operation andmaintenance will continue to be important.

The policy and institutional framework

A recurrent theme in this volume is the impor-tance of a clear policy and institutional frame-work for private involvement to simultaneouslytackle four related objectives:

¥ Reducing the price distortions and risk fac-tors that are central causes of the weakpipeline of bankable projects.

¥ Ensuring that projects are approved efÞ-ciently, fairly, and in a timely fashion.

¥ Ensuring that private providers deliver high-quality services efÞciently and at reasonablecost.

¥ Dealing with important societal concernsabout the environment, resettlement, and theprovision of basic services to the poor.


Box 1.2 Managing guarantees in the Philippines

In July 1987 the Philippine government launched a programto attract private investment for power generation (WorldBank 1994, p. 67). The government provided full faith andcredit guarantees to back the obligations of the NationalPower Corporation under long-term power purchaseagreements with private suppliers. These guarantees cov-ered the entire risk of the corporation’s payments: failure topay for any reason would trigger the guarantee. With muchexperience in private power generation and thus a trackrecord of honoring payment obligations, the government isin a position to scale back on the guarantees it provides. In1995 it adopted a policy aimed at doing so, with four objec-tives:

• To unbundle the risks so as to be able to sharplydemarcate covered risks.

• To reduce coverage to 75–80 percent of paymentobligations.

• To introduce the concept of guarantee “fallaway”(for example, the guarantee of foreign exchangecoverage falls away when the Philippine govern-ment achieves an investment-grade credit ratingand retains that rating for two years).

• To create administrative mechanisms for morecareful review, pricing, and budgeting of guaran-tees, including possibly retaining reserves againstguarantee claims.

The principles of risk unbundling, reduced coverage,and guarantee fallaway have already been adopted in somerecent guarantees. Now the Philippine government is inves-tigating options for a present value budgeting system thatwould reduce the budgetary incentives to provide guaran-tees (such incentives arise because issuing a guaranteerequires no cash, so that no financial charge is made againstthe department or agency authoring the guarantee).

Source: Philippines 1995.

Not all elements of the framework need be inplace before private entry begins. Indeed, manyconference participants emphasized that there isno magic formula, and most countries have beenproceeding in an evolutionary, learning-by-doing fashion. But an evolutionary policy doesnot come without costs. From the perspective ofpotential private investors, evolution is policyinstability and a lack of strategic commitment,and it can substantially raise their perceivedrisks and required returns. Addressing theseconcerns sometimes will mean striking a bal-ance between efÞciency and the need to main-tain commitments to the private sector when therules of the game change because of deeper sec-toral reforms, as authorities in Victoria,Australia, did in grandfathering a guarantee toa major power project.

In laying out the elements of a sustainablepolicy framework, conference participantsemphasized two aspects of infrastructure deliv-ery. First, there are different phases in an infra-structure project and each has distinct risks (box1.3). Private sector representatives expressedgreat concern about risks in the developmentphaseÑin the contracting process, the grantingof permits, and the management of environ-

mental and resettlement issues. There was alsoconcern about risks during the operationalphase, such as changes in contractual agree-ments (including early termination), inability toobtain payment for services rendered, andinability to convert domestic into foreign cur-rency. Projects in water and transport may alsoface direct market risk. Recognizing these risksis a Þrst step in designing government policiesand institutions that minimize them.

Second, there are important differencesbetween infrastructure activities that are poten-tially competitive and those that are intrinsicallymonopolistic (box 1.4). Natural monopoliesrequire special measures to prevent the grantingof favors to potential monopolists, limit theabuse of monopoly power, encourage efÞcientservice provision, and ensure the maintenanceof asset quality. Much of the initial private sec-tor activity in East Asia has been in telecommu-nications and power generation, bothpotentially competitive activities.

The following sections outline how the fourobjectivesÑreducing price distortions and riskfactors, ensuring timely and fair projectapproval, ensuring low-cost, high-quality ser-vices, and addressing societal concernsÑcan beachieved, in monopolistic and potentially com-petitive activities and in all project phases.

Managing the transition in potentiallycompetitive activities

The countries that have gone furthest in privateinvolvement in infrastructure have all used com-petition in power and telecommunications. Ofthe countries represented at the Jakarta work-shop, Australia, Chile, and Malaysia have multi-ple, competing operators in telecommunications.This approach is based on the view that, sincethere are several technical options for supplyingservices (radio, satellite, cable networks, tradi-tional wire lines), there is little reason to restrictnew entry into telecommunications networks. Inpower generation Chile and the Australian stateof Victoria have competitive structures.

Competition in East Asia is extremely lim-ited, even in telecommunications. Indonesia andThailand have awarded private telecommunica-tions providers concessions to serve speciÞc


Box 1.3 Risks along the project cycle

Project development, when risks are greatest, is financedalmost entirely with equity funds. A drawn-out contractaward process and a lack of transparency can greatly increaseproject preparation costs, so high returns are expected fromthis exploratory work.

During the construction period project sponsors typi-cally seek 70 percent debt financing. Since capital marketstend to be cautious about financing construction, banks arecalled on to play a prominent role, and because of the risksdemand relatively large spreads. Since commercial bankresources are limited—and there are few banks experi-enced in international project finance—it is important torecycle bank resources into new projects by refinancing pro-jects through capital markets once they are operational. Inprinciple, governments do not bear construction risk in mostprojects, but as ultimate guarantors in many projects they dobear residual risk.

Once projects are up and running, cash flows are sub-ject to market and regulatory risks. The solution is to reducethe regulatory risks before operation by establishing soundsectoral frameworks, including for the environment and forresettlement.

geographical areas, but have also granted themmonopoly rights in those areas. Awarding con-cessions to several providers creates the poten-tial for ÒyardstickÓ competition, in whichsuppliers are rewarded on the basis of compar-isons with suppliers in other jurisdictions, butthis type of competition is necessarily weakerthan direct competition.

In power generation in East Asia privateentry has been through long-term, take-or-paypower purchase agreements between privatesuppliers and government-owned power com-panies. Under a take-or-pay contract the powercompany makes a commitment to pay the pri-vate operator a capacity fee, which typically cov-ers at least debt and operating costs, whether ornot it actually uses the power. Thus, even wherethere are multiple private generators, they donot compete directly. Investments under suchcontracts typically occur through build-operate-transfer (BOT) arrangements and are primarilya device to help governments Þnance newcapacity by deferring payments.

The experiences of both Chile and Victoria,Australia, in introducing competition in powersupply illustrate gains in both efÞciency and

investment. Victoria attracted surprisingly highbids on assets sold even without offering a com-mitment through a take-or-pay contract (box1.5). While the models for introducing competi-tion differ from one country to another, theyshare the goal of stimulating competition forÒspotÓ supplyÑthe daily supply to the trans-mission grid. In spot markets only the plantsable to win the right to supply the daily gridrequirements on the basis of their low costs arepaid. There is an incipient movement in thePhilippines to create competition in power sup-ply along these lines.

Other countries in East Asia are also consid-ering sectoral reforms in power. Reform is highon the agenda in China, for example. Countrieswhere private entry is at an early stage can skipthe stage based on BOTs and power purchaseguarantees. But there are important precondi-tions for successful competition. The utility buy-ing power must be creditworthy, or new entry isunlikely to occur. Price reforms are necessary toensure the sectorÕs viability. Reforms of thepower utility may also be needed, often includ-ing privatization. And competition requires aregulatory infrastructure, including Òpower


Box 1.4 Policy issues in competitive and monopolistic infrastructure sectors

Potentially competitive sectors (electricitygeneration, long-distance telecommunications)

Natural monopolies (electricity transmissionand distribution, toll roads, ports, watersupply)

• Designing market structures for the publicto private transition • Establishing rules for environmental andresettlement issues • Reducing the public sector’s direct role incontracting

• Efficiently managing the contracting process,using “competition for the market”• Managing environmental and resettlementissues

• Implementing general competition policy,including network interconnectionarrangements • Providing explicit subsidies for basic servicesfor the poor

• Regulating the sector to ensure fair pricing,low-cost service delivery, high-quality service,and adequate future investment • Providing explicit subsidies for basic servicesfor the poor

Policy objectives in competitive and monopolistic infrastructure sectors

Development phase Service delivery phase

Technological change has made power generation and long-distance telecommunications potentially competitive and willsoon do the same for electricity distribution and local calls.Many other activities are at least in part natural monopolies,especially network industries, such as electricity transmission,gas and water supply, and road and rail transport.

Different policy issues arise in monopolistic and competi-tive activities. In natural monopoly sectors consumers can often

turn to higher-cost alternatives, such as water vendors, alter-native energy sources, or competing transport modes. But sub-stantial market power and special pricing problems remain aspolicy issues. Competition is a desirable goal, but achieving andenforcing it can be a demanding task for policymakers. Relapsesinto monopoly characteristics are common.

Source:

poolsÓ and mechanisms to ensure fair dispatch(and thus the choice of generating plants withthe lowest marginal cost of supply).

Competition eases the task of regulation,since it fosters efficiency and fair pricing. Butmerely permitting new entry is not alwaysenough to make market structures competi-tive. Market structures created at the time ofrestructuring or privatization can have long-lasting influences. Chile allowed a verticallyintegrated power company, creating a poten-tial for the company, as owner of the grid, togive preference to the generating plants itowned. By contrast, Victoria, Australia, movedto five generating companies and an indepen-dently owned grid when it deregulated. Evenafter the principle of competition is estab-lished, the regulator or competition authorityneeds to keep an eye out for anticompetitivetendencies.

Ensuring competition for the market and timelyand efÞcient contracting

Many infrastructure projects are not in compet-itive activities, either because they are naturalmonopolies or, as in much of the power andtelecommunications investment in East Asia,because service provision has not yet beenderegulated. Investment in noncompetitiveactivities generally implies direct governmentmanagement of the choice of project and theaward of contract, an approach that raises dif-ferent concerns for the public and private sec-tors. Government representatives at theconference particularly emphasized the need toensure fair deals for society and avoid the exces-sive proÞts (and political fallout) associatedwith highly favorable contracts. Private sectorrepresentatives expressed concern about lack ofclarity in the rules of contracting and the cost ofthe process, which is Þnanced entirely withequity and must therefore yield a high return.

Where direct competition in supply is lim-ited, another potential source of discipline iscompetition Òfor the market,Ó or for the right tosupply. Such competition requires governmentsto identify projects, invite competitive bids, eval-uate the bids, and award contracts. To exploit thepotential of such competition, governments needto establish the basic rules and legal frameworkfor eligible projects, identify qualiÞed suppliers,and conduct individual transactions that resultin prices that are fair and beneÞcial to consumers


Box 1.5 Beyond power purchase agreements—man-aging the transition to competition in power generation

In the Philippines a framework for competitive electricitysupply is beginning to emerge and will probably be put inplace in the next three to five years. The country will thenhave to decide how to handle existing power purchaseagreements. For guidance, it can look to the Australian stateof Victoria, which has already made the transition to com-petition.

The first major private entry in Victoria’s power gener-ation sector was through the sale of the half-finished, 1,000-megawatt Loy Yan B plant. Negotiations were long, costly,and complex but eventually ended in a deal involving a thirty-three-year take-or-pay power purchase agreement and thestate electricity utility taking all the construction risk . WhenVictoria later introduced full competition in generation andcomplementary reforms in transmission and distribution, itchose to grandfather the power purchase agreement withLoy Yan B in order to avoid destabilizing the business envi-ronment—despite potential efficiency losses.

The priority given to a stabile business environment,combined with deep sectoral reforms, has led to strong pri-vate interest—without the government having to offer guar-antees. One measure of private interest is the purchase ofthe thirty-year-old Hazlewood power plant for three timesits book value, with no power purchase agreement. Thissale, along with sales of distribution companies, has helpedtransform the state’s finances.

Source: Chapter 2 in this volume.

Box 1.6 Leaving the contracting choice to themarket—the gas pipeline in Chile

A pipeline to transport natural gas over the Andes fromArgentina is an important option for energy supply in Chile.Once constructed, such a pipeline would be a naturalmonopoly. Negotiations to construct a pipeline startedbetween the government and potential developers, whoemphasized the need for government guarantees to makethe project viable. But the government, judging that it hadlittle basis on which to negotiate, left the developers to nego-tiate directly with the potential users. Of the two consortiathat competed for the right to serve customers, one even-tually struck a deal with a group of consumers at a price farlower than that originally proposed to the government—with no government guarantee of the purchase contracts.


and are perceived as such. Where privateinvolvement is mature and consumers are wellinformed, the government can withdraw fromthe contracting processÑas the Chilean govern-ment did in natural gas supply (box 1.6).

East Asia already has some of the basic legalstructure in place for private sector entry, but alarge agenda of legal reform lies ahead. In suchcountries as Cambodia, Mongolia, and Vietnam,where no private projects have been imple-mented, the rules for BOT projects are still in theearly stages of development. In China severalprivate projects are in operation, but the BOTpolicy continues to evolve. Laws permittingwater and road concessions are needed in mostcountries, as are extensive legal changes to allowprivatization of state assets. Several conferenceparticipants stressed the need for a legal struc-ture that would increase conÞdence in the con-tracting process among potential suppliers andeventual consumers and thus lower the costs ofcompleting transactions.

The economic and social beneÞts of a projectalso depend to a great extent on how the contractis procured. While the choice between competi-tive and noncompetitive procurement is oftenÑand quite rightlyÑemphasized, other featuresof the transaction can also substantially inßu-ence the outcome. Early contracts in a country orsector are often negotiated directly with selectedparties rather than being offered for competitivebid. The Philippines, for example, used directnegotiations in its initiative to attract privateinvestors to the power sector during the emer-gency period of blackouts. But in recent transac-tions it has relied on competitive sourcing;several bidders have typically responded,resulting in substantial competition and a steadylowering of the purchase price for power.Another successful example of competitive pro-curement has been in Thailand, where bidderswere invited concurrently to bid on projects toprovide up to 4,000 megawatts of power.Competition was extensive, and commitmentsto supply were obtained at the low end of theinternational range. Competitive bidding wasalso effectively used in Indonesia for telecom-munications contracts.

The disadvantages of noncompetitive bid-ding processes are well known: high prices and

indifference to consumer needs often result. Butdespite the obvious beneÞts of competitive bids,many projects are still procured through directsolicitation or in response to private sector pro-posals. For example, in Malaysia, which has thelargest portfolio of private projects in East Asia,virtually all projects have been directly pro-cured. Proponents of noncompetitive bids citeseveral beneÞts. The procurement process takesless time. Overall preparation costs are lower,since the costs that would have been incurred byunsuccessful bidders are eliminated. And unlikein a competitive situation, where all biddersmust respond to a common basic request for pro-posals, the private sponsor has the opportunityto show innovation in project design.

Examples presented at the conferenceshowed that the gap between competitive andnoncompetitive contracting can be narrowed byoverlaying on one the positive features of theother. For example, a government could subjecta sole-source bid to an open and competitiveprice challenge before the award, while givingthe initial bidder some preference based on itsearly design and development costs. The costs ofproject preparation could be subsidized toattract a larger number of bidders, a practiceused in the United KingdomÕs private sector ini-tiative and likely to be adopted in thePhilippines. In South Australia authorities con-ducted a negotiation process with competingbidders that was akin to that for sole-sourcedcontracts (see box 1.7). Whatever the approachto contracting, preparatory work by the govern-ment is critical to success.

Just as competitive and noncompetitive con-tracting can share the presumed beneÞts of theother, they can also share each otherÕs presumedills. Transparency of process, with a heavyemphasis on information disclosure, is critical,regardless of whether a contract is procured com-petitively. While a suspicion of political patron-age is almost inevitable in directly negotiateddeals, a competitive process can also be taintedÑor at least perceived to be so. There should be nopresumption that competitive bidding will befairly and transparently conducted. Witness theheavy controversy surrounding the award of awater treatment contract in Thailand and a set oftelecommunications contracts in India. Lack of


clarity on the criteria used in choosing the win-ning bidder and a perception that the rules of thegame have changed midway through the bid-ding process are typical sources of controversy.

Three messages emerge from the experiencein contracting for infrastructure provision.Competition can bring major gains in price.Whether the contracting is competitive or not,transparency is highly desirable on both efÞ-ciency and political grounds. And some of thepositive features of direct negotiations can beincorporated into competitive bidding.

Using regulation to promote efÞciency

However carefully contract award is conducted,it generally must be followed by continual pro-ject oversight to ensure that contract terms aremet and that unexpected effects are not interfer-ing with societal concerns. Such ongoing over-sight is referred to as regulation. As withcontract award, the processÑand thus the trans-parency and accountabilityÑof regulation is atleast as important as its technical features.

East Asia has limited experience with mod-ern regulatory practices, but conference partici-pants agreed that the regionÕs governmentsneed to adopt such practices. These practicesincreasingly are based on exploiting the incen-tives of service providers to behave in a sociallydesirable manner. This Òincentive regulationÓminimizes the information required by the reg-ulator to do its job. By contrast, rate-of-returnregulation, now rarely used, imposes high infor-mation requirements. In this type of regulationprices are set so as to ensure that the providerreceives a speciÞed rate of return, a system thatcreates a perverse incentive for the provider toincrease capital costs while giving the regulatorthe difÞcult task of determining the appropriatelevel of investment. Another, increasingly pop-ular method of price regulation limits prices (ortheir rate of growth) rather than rates of return.Under this Òprice capÓ system providers have anincentive to minimize costs.

A price cap system does require benchmarkestimates of rates of return at the time the cap, orlimit, is established. But once set, price caps needbe adjusted only every Þve to seven years, lim-iting the information required for effective reg-

ulation. Price caps are being used in power gen-eration contracts throughout East Asia,although an important contract for a nationalsewerage system in Malaysia is being regulatedon a rate-of-return basis.

Regardless of the method of regulation, mea-sures are required to ensure the accountabilityand independence of regulators so that theirdecisions will carry authority. If the relationshipbetween the regulator, the legislature, and theexecutive is blurred, as it typically is, it will needto be clariÞed. One view holds that the regulatorshould be accountable to the legislature, withregulatory commissions staffed by memberswith overlapping terms so that an entire com-mission cannot be summarily dismissed.

Dealing with broader societal concerns

Discussions in Jakarta emphasized the impor-tance of dealing with societal concerns explicitly


Box 1.7 Managing competition in contracting—South Australia’s experience in water supply

The award of a water supply contract in South Australiashows how a competitive bid can incorporate some of thepresumed benefits of directly negotiated contracts.

• Prospective bidders were provided detailed tech-nical and financial information based on past oper-ation by the public sector, but they also wereinvited and expected to undertake their own duediligence, including assessing demand.

• The authorities announced detailed criteria forchoosing the winning consortium and for con-ducting any renegotiations. Renegotiation canoccur even in competitive situations, and prespec-ifying the criteria to be used ensures greater trans-parency.

• After receiving proposals from four prequalifiedbidders, the authorities entered into a relativelynovel—and potentially delicate—set of parallelnegotiations with the bidders. They took elaborateprecautions to prevent the abuse of confidentialinformation, and they validated the assumptionsunderlying each bidder’s proposal, limiting thepossibility of postcontractual renegotiations.

• The bidding process was completed in eighteenmonths under the supervision of highly experi-enced professionals, including international con-sultants.

Source:

and early, often with both public and privateinvolvement. Doing so allows risks and oppor-tunities to be addressed efÞciently. For example,dealing with environmental and resettlementconcerns during project development opensopportunities for innovative, Òwin-winÓ solu-tions. Similarly, to ensure that the goals ofexpanded service coverage and affordable ser-vices for the poor are met, they need to be clearlystated up front and reßected in the regulatoryframework and pricing structures.

Resettlement is frequently an important con-cern in infrastructure projects, particularly intransportation and hydroelectric projects, and itcan become a major source of project risk if notcarefully handled. Governments in East Asia aredevising policies and procedures for resettlingthose displaced by infrastructure projects.Projects involving international lending agen-cies face increased pressure for effective designand implementation of resettlement plans. Buteven in projects with purely private investment,the risk of political opposition requires activegovernment involvement to ensure that the con-cerns of those affected are fairly and equitablyaddressed through consultation, choice of suit-able relocation sites, and adequate support(including compensation) to restore long-termincomes (box 1.8).

Dealing with environmental concerns simi-larly requires careful, thorough planning. Mostproject sponsors tend to view environmentalconcerns as a source of increased project cost andrisk, both during project development and lateron, as unexpected liabilities arise due to changesin regulation and the discovery of sensitive envi-ronmental problems. But perceived risks canoften be turned to the advantage of both devel-opers and society when improved environmen-tal performance goes hand in hand withincreased operating efÞciencyÑas it can inwater, energy, and transportation projects (chap-ter 5). To realize this potential for mutual bene-Þt, regulators must be clear about theperformance standards the project sponsorsmust meet and allow them sufÞcient ßexibilityin operations.

In most countries many people, both poorand nonpoor, lack access to electricity, tele-phones, and piped water supply. Often they end

up paying much higher prices for these servicesfrom alternative sources, such as for water fromvendors. Many societies have made ensuringminimum access to basic services a policy objec-tive, especially middle-income countriesapproaching universal access. This often impliessubsidizing access for some of the poor, poten-tially jeopardizing the commercial viability ofservice supply. Economists generally agree thatthe best approach for achieving minimum accesswhile safeguarding commercial viability is toprovide an explicit subsidy for targeted house-holds. A common practice under Argentinewater contracts, for example, is to bill fully forservices, but to have households pay only partof the bill and charge the government directlyfor the subsidized portion. In Chile the subsidiesfor rural electriÞcation are built into contractsthat are then competitively bid.

Issues relating to sector regulation, contract-ing, resettlement, the environment, and reach-ing the poor converge in the water supply sector.Few deals in water supply have been Þnalizedin East Asia outside of Malaysia, but conferenceparticipants showed much interest in the sector.


Box 1.8 Involving the private sector in resettlement

Where truly voluntary resettlement occurs—when land ispurchased through fair negotiations—the private sponsorsof the project can take the lead in addressing the issues. Butwhere involuntary resettlement is necessary, the relationshipbetween the government and the private sponsors is oftenantagonistic. Private sponsors will be unwilling to commit sig-nificant new investment because of the uncertainties in pro-ject design and timetables. Governments may offer toundertake the resettlement and even offer financial com-pensation in the event of delays. But such commitments arenot always credible, at least in part because the governmentactions will be subject to international scrutiny.

Close public-private collaboration may offer the way tomore humane resettlement at lower cost and in less time.The private sector can play an important supporting role,although the government must be prepared to take the lead.The government must set up the consultative process andthe guidelines to ensure fair compensation for those to beresettled and to protect their livelihood. But once suchguidelines are in place, the private project sponsors can workalongside government agencies in implementing resettle-ment—designing and developing new sites and offering thepeople affected work on the project and in spin-offs.


Because of the complexity of the issues in thewater and sanitation sector, it is an importantnew frontier for public-private partnership inthe region (box 1.9).

Capital Markets and Domestic Finance forPrivate Infrastructure

In most East Asian economies the bulk of Þnancefor private infrastructure has come from foreignsources. Yet most of the revenues from infra-structure projects are in domestic currency, rais-ing the risk of currency devaluation and foreignexchange inconvertibility for foreign investors.The risks for foreign Þnance of private infra-structure increase the importance of domesticÞnance. But only about a quarter of the Þnancefor private infrastructure in East Asia comesfrom domestic sources.

Why has there been so little domestic Þnanc-ing for private infrastructure? The low levels inEast Asia today are not without historical prece-dence. Much of the Þnancing for some of theinfrastructure developed in North and SouthAmerica in the nineteenth century came from the capital markets of the United Kingdom(Eichengreen 1996). But domestic savings in therecipient countries were low. By contrast, EastAsian economies have some of the highest sav-ings rates ever recorded (Þgure 1.5). Total sav-ings are running at 30Ð35 percent of GDP, andprivate savings at 25Ð30 percent. Moreover, a sig-niÞcant share of the savings is going into Þnan-

cial assets, with bank credit, for example, com-parable to levels in some industrial countries(Þgure 1.6).

So the issue is clearly not a lack of domesticresources. Even if the private sectorÕs share ininfrastructure investment in East Asia reaches 30percent in the next few years and more than 50percent by early in the next century, it would stillamount to only 2Ð5 percent of GDP, a small frac-tion of private domestic savings. Instead, thelow domestic Þnancing for private infrastruc-


Because water is a basic necessity and clean water is requiredto prevent the spread of disease, universal access to affordablewater is a high priority everywhere. But throughout East Asiawater supply systems are under great stress as rapidly growingurban populations place increasing demands on them.Perversely, in many systems subsidies have limited the expan-sion of supply while failing to benefit the poor, many of whomlack access to the public system and buy water at high pricesfrom private vendors. Sewerage systems are even less devel-oped and service prices are much too low to cover the sub-stantial investments required. As a consequence, poorsanitation is a growing threat to public health and the environ-ment in many countries.

Private entry into water and sanitation has been con-strained by system inefficiencies, uneconomic pricing, and gov-

ernments’ reluctance to award monopoly distribution rights insuch a sensitive sector. Some contracts have been awarded toprivate operators—a water and sewerage contract in Manila, asewerage contract in Malaysia, a management contract for thewater distribution system in Macao, water sourcing and treat-ment contracts in Malaysia and Thailand—and similar contractsare under discussion in Chinese and Indonesian cities. But theneeds extend well beyond these early efforts.

Regulating the water and sanitation sector is a challengebecause large investment requirements and high environmen-tal standards imply a need for long-run price increases.Balancing the goals of expanding access, including to the poor,protecting the environment, and preventing abuse of monop-oly rights creates a policy challenge that can be met onlythrough increased experience and public-private collaboration.

Box 1.9 Water supply and sanitation—regulation, the environment, and the poor

Figure 5 East Asia has extraordinarily high savings . . .Gross domestic savings as a percentage of GDP, 1993–95

Source: World Bank.

0 10 20 30 40 50

Philippines

Argentina

Mexico

India

Brazil

Germany

Japan

Hong Kong, China

Developing East Asia average

Korea, Rep. of

Indonesia

Thailand

Malaysia

China

Singapore

ture stems from a combination of relativelyimmature domestic capital markets, especiallybond markets, and domestic investorsÕ cau-tiousness about such investments. Apparently,domestic investors are more averse to the risksassociated with the present phase of infrastruc-ture investment than are foreign investors, whohave greater opportunities for diversiÞcation. Inthe coming years use of domestic equity marketsis likely to grow rapidly, but long-term domes-tic debt Þnance will probably lag in most coun-tries, taking off only when domestic contractualsavings become signiÞcant, as has occurred tosome extent in Malaysia. (Contractual savingshave also been used in Singapore, but in a pre-dominantly public sector context.)

Equity markets

Despite East AsiaÕs gradual approach to privati-zation of state-owned utilities, almost $11 billionwas raised on foreign and domestic stock mar-kets in 1989Ð95 (compared with $28 billion inLatin America), almost entirely for power, trans-port, and telecommunications (table 1.2). Forexample, PT Telkom, the Indonesian telecom-munications company, went to the market withan initial public offering in November 1995 andraised $1.69 billion, mainly onshore, on theJakarta and Surabaya stock exchanges and laterraised some $600 million through an onshoreprivate placement. The private Indonesian tollroad company, Citra Marga Nusphala Persada,also has raised some $600 million on local stockmarkets. But with foreign investors accountingfor almost 80 percent of trading on the Jakartaexchange, and about 50 percent in Bangkok,Kuala Lumpur, and Manila, the estimate ofonshore Þnance includes a large share of foreignÞnancing.

Stock markets are likely to become an impor-tant source of Þnance for infrastructure compa-nies in East Asia. Although the depth andinstitutional framework of the regionÕsexchanges are less well developed than those ofmature exchanges, stock markets throughout theregion are growing and deepening fast. By oneestimate the Kuala Lumpur exchange saw a dou-bling in efÞciency between 1992 and 1996, andthe Jakarta exchange improved nearly as fast.

Although East AsiaÕs stock markets are stillyoung, capitalization in several is comparable toor greater than that in rich countriesÑand isgrowing fast (Þgure 1.7). Stock market capital-ization in Hong Kong (China), Malaysia, andSingapore was more than 200 percent of GDP in1995¾substantially greater than in the UnitedKingdom and the United States. The exchangesin Thailand and the Philippines also had high


Table 1.2 Equity market financing of infrastructure privatization in East Asia and Latin America, 1989–95(US$ billions)

East Asia Latin America

Sector Onshore Offshore Total Onshore Offshore Total

Transportation 2.2 1.2 3.4 3.1 0.9 4.0Telecommunications 1.7 2.2 3.9 4.3 11.4 15.7Power 2.5 0.9 3.4 3.9 4.4 8.2Other 0.1 0.1 0.2 0.1 0.0 0.1Total 6.5 4.3 10.9 11.3 16.7 28.0

Source: World Bank, International Economics Department, Privatization Database.

Figure 6 . . . much of it channeled into financial investmentTotal credit provided by the banking sector as a percentage of GDP, 1995

Source: Walton.

0 50 100 150 200 250 300

Argentina

Brazil

India

Indonesia

Mexico

Philippines

Korea, Rep. of

Singapore

China

Average for developing East Asia

United Kingdom

Germany

Malaysia

United States

Thailand

Hong Kong, China

Japan

levels of capitalization (though ThailandÕs hassince fallen back). Finance from stock marketswill, of course, depend on the perceived riski-ness of projects. In mid-1997 Malaysianinvestors showed signs of caution over someinfrastructure projects: a June 1997 rights issuefor the Þnance of the 2,400-megawatt BakunDam was reported to be 63 percent undersub-scribed (Financial Times, June 12, 1997).

A relatively new development is the raisingof funds through securities backed by pooledinfrastructure assets. Several Chinese pro-jects issued such securities to raise Þnancing onthe Hong Kong (China) and the domesticShenzhen stock exchanges. For example, in 1996the Guangdong Provincial ExpresswayCompany raised HK$477.9 million (US$62 mil-lion) through an issue of B shares on theShenzhen exchange, backed by stakes in com-pleted revenue-generating toll projects, includ-ing the Jujiang Bridge and Guangzhou-Foshanexpressway. The money raised was used toÞnance additional investment. In late 1996 theAnhui Expressway Company raised $100 mil-lion on the Hong Kong (China) exchange toÞnance three highway projects, with the com-panyÕs balance sheet secured by the HeningExpressway, already in operation. This use of

assets (originally Þnanced by public or privateequity or debt Þnance) to raise resources onlocal and international capital markets toÞnance additional investments could emerge asa signiÞcant pattern.

Debt Þnance and bond markets

While there has been signiÞcant activity on EastAsiaÕs domestic equity markets (though much ofit involving foreign investors), domestic debtÞnance of private infrastructure has been rela-tively limited. Does this reßect failure by thedomestic Þnancial system to efÞciently interme-diate private savings into proÞtable investmentopportunities? The answer is yes, but the prob-lem relates to the current phase of Þnancial mar-ket development rather than short-run policy.Banks still dominate East Asian Þnancial sys-tems and account for the bulk of private savingsin Þnancial instruments. Deposits are mainlyshort to medium term, limiting banksÕ ability tomake the long-term investments typical in infra-structure projects. East Asian banks also haveless capacity to support large-scale projects thando the much larger and Þnancially strongerinternational banks.


Figure 8 Bond markets are still relatively undeveloped in East AsiaBond market capitalization as a percentage of GDP, 1990 and 1994

Source: World Bank.

0 20 40 60 80 100 120

19941990

Indonesia

China

Hong Kong, China

Thailand

Korea, Rep. of

United Kingdom

Philippines

Malaysia

Singapore

Japan

Germany

United States

Figure 7 Stock market capitalization in several East Asianeconomies is high and growing fastStock market capitalization as a percentage of GDP, 1990 and 1995

Source: Walton.

0 50 100 150 200 250 300

19951990

China

Argentina

Brazil

Germany

Indonesia

Mexico

India

Average for East Asia

Korea, Rep. of

Japan

Philippines

Thailand

United States

United Kingdom

Singapore

Hong Kong, China

Malaysia

Financing infrastructure through long-termbonds is an attractive option in principle. Bondmarkets were an important source of Þnance inearlier eras of private infrastructure, notably inthe building of transport networks in North andSouth America (see Eichengreen 1996). In themore recent past bond Þnance was used primar-ily by state corporations¾as in French powerinvestments and the U.S. Tennessee ValleyAuthority. In Indonesia the state-owned powercompany Perusahaan Listrik Negara (PLN) hassimilarly made use of the local bond market,becoming one of the major market players. Itmade its Þrst bond offering in 1992, of 300 billionrupiah (Rp), and issued another Rp 2.6 trillion atthe end of 1996, mainly of Þve- to seven-yearmaturities. In general, however, bond markets inEast Asia are relatively undeveloped, withturnover much lower than in the developedmarkets of industrial economies (Þgure 1.8).

The use of bonds in limited recourse projectÞnance has emerged in recent years. The issueshave been placed in relatively well-developedÞnancial markets, primarily the U.S. 144a mar-ket (which permits resale of purchased securitiesto qualiÞed investors). Institutional investors,primarily insurance companies and pensionfunds have been the major purchasers of thesebonds (box 1.10). Because institutional investors

manage contractual savings with long maturi-ties, long-gestation infrastructure projects arepotentially attractive investment opportunitiesas long as risks are adequately addressed.

Most developing countries have a relativelysmall pool of institutional investors, however.Two of the exceptions are Chile and Malaysia. Inboth countries pension funds have played animportant part in infrastructure Þnance,although under very different market condi-tions. In Chile pension funds are private andautonomous, and they compete for resourcesfrom individual workers, though within fairlynarrow limits. The government has steadilybroadened the range of assets that pensionfunds may purchase. In Malaysia there is muchgreater state involvement in the economy, andthe Employee Provident Fund is a public entitywith relatively restricted investment options.Until recently the fund held the bulk of itsinvestment in government bonds (and still holdsabout half in this instrument), but it is now pur-suing a more diversiÞed investment policy.

Bond markets in East Asia are relativelyunderdeveloped in part because of the relativelylow issuance of government bonds, which usu-ally provide the core of the bond market¾andthat in turn stems from the low levels of deÞcitÞnance. Underdeveloped bond markets also


Chile. Chile’s independent pension funds have become majorplayers in domestic infrastructure finance, through purchases ofboth bonds and equity. Since they were privatized, the fundshave channeled some $4.8 billion into electricity and gas dis-tributors and $1.6 billion into telecommunications companiesand are becoming increasingly involved in transportation.

Malaysia. The first independent power project awarded inMalaysia, the YTL power generation project, was financedentirely in local markets, including through a 1.5 billion ringgit(RM) (almost $500 million), ten-year bond subscribed by theEmployee Provident Fund and a RM 1.6 billion floating rate loanunderwritten by local banks to finance construction.Subsequent projects using bond finance have included otherpower projects (Lumut Power) and transport projects (theNorth-South Expressway). The Employee Provident Fund hasbeen active in most of these bond issues.

The Netherlands. The Wijkertunnel was the first project incontinental Europe to be financed through domestic markets.It raised most of the tunnel’s $342 million cost through privateplacement of bonds with Dutch insurance and pension funds

(the Netherlands is unusual in Europe in having fully fundedpension schemes).

The United Kingdom. The First Hydro project involved thefirst-ever use of a sterling eurobond issue for project finance.This hydro plant was bought by Mission Energy in 1995 andrefinanced through issuance of £ 400 million of 25.5-yeareurobonds. Most of the bonds were purchased by British insur-ance companies.

The United States. The Independence FundingCorporation, which owns a 1,000-megawatt gas-fired cogen-eration plant in New York State, was the first independentpower producer in the world to receive an investment-graderating and obtain finance through the capital markets. Backedby strong power offtake agreements, its successful offering in1993 of secured notes totaling $717 million was purchasedmainly by U.S. institutional investors. In 1995 California Energyissued $200 million of limited recourse, below-investment-grade bonds with eight-year maturities.

Source:

Box 1.10 Contractual savings in long-run finance for infrastructure

reßect the relatively limited use of externalÞnance by the corporate sector, owing to thedominance of family Þrms. Bond markets arecertainly growing in importance, and the insti-tutional framework is likely to improve rapidly,as it did for equity markets, with the develop-ment of benchmarks, improved settlement andclearance procedures, and an information infra-structure (World Bank [Asian Bond MarketStudy]).

As emphasized throughout this volume,however, infrastructure investments continue toinvolve signiÞcant risks, a concern for investorslooking for the relatively moderate but securereturns characteristic of bond markets.Experience suggests the need for caution in forc-ing the pace: many technically autonomouspublic pension funds in Latin America saw asubstantial share of their investments channeledinto low-return activities. More important is toreduce the risks faced by infrastructure projectsand to foster the development of genuinelyautonomous contractual savings institutionsthat will make prudent decisions on purchasesof infrastructure bonds and other savings instru-ments. With further pension reforms likely inEast Asia and great potential for growth in lifeinsurance, large growth can be expected in thesavings available for long-term investment. Butthis growth will not happen overnight.

A framework for moving forward

There is no magic formula for accelerating pri-vate sector involvement in infrastructure, butthere is a set of common principles for fosteringsuch involvement while achieving efÞciencygains and meeting societal goals. These princi-plesÑtransparent processes, stable rules, pricereforms, maximum competition, and incentive-based regulatory structuresÑare the pillars of abasic framework that each country can cus-tomize to Þt its priorities and institutions.Developing effective frameworks for privateparticipation will be an evolutionary process ascountries learn from their experience. But sys-tematic sharing of information among EastAsian economies and with other countries at allstages of development will speed this process. Itmay also enable late starters to skip the Òlearn-

ing-by-doingÓ phase, jumping directly to deeperreforms and the gains they bring in efÞciency,investment growth, Þnance, and public conÞ-dence.

The Jakarta dialogue and other public-pri-vate forums organized by the World Bank con-Þrm that while private participation ininfrastructure is new and the issues complex, arich body of experience is fast developing. Thisexperience reveals major differences betweensectors and countries, suggesting that no onemodel is universally applicable. Yet the discus-sions between policymakers and private execu-tives have identiÞed common principles andstrategies that can help countries shorten thelearning curve and develop more effective waysto promote private participation (Kohli 1997).

Among the lessons that have emerged fromsuch discussions are the preconditions neededto ensure the sustainability of large-scale privateinvestments in infrastructure:

¥ Projects must produce services at prices thepublic is willing to pay.

¥ Where government subsidies or other formsof support are essential, they should be trans-parent and sustainable.

¥ Private projects must be Òbankable,Ó that is,their Þnancial returns must be commensu-rate with the risks perceived by privateinvestors and Þnanciers.

To meet these preconditions, most countriesneed to undertake far-reaching policy and insti-tutional reforms to improve the Þnancial viabil-ity and proÞts of infrastructure projects, increasecompetition and transparency in contracting,and reduce the risks of investing in the sector.Such reforms build credibility with both the gen-eral public and private investors.

The goals set for private participation frame-works vary among countries and sectors andcontinue to evolve. But they are likely to include:

¥ Price reforms that ensure sustainable rev-enues and reduce future price uncertainties.

¥ A more transparent and credible regulatoryand legal framework.

¥ Greater competition (including the breakupof monopolies, whether public or private).

¥ Direct relations between the ultimate con-sumers and suppliers to enhance account-ability.


¥ Separation of sovereign and commercialrisks to allocate risks efÞciently.

¥ The development of domestic capital mar-kets and of mechanisms to facilitate provi-sion of long-term debt, including the creationof Þxed income securities and bond markets.Most developing economies in the region are

addressing many of these constraints and issues.But almost all are focusing on the needs of a fewprojects or sectors, addressing only some of thecross-sectoral issues, and pursuing reformsmore slowly than desirable. At this pace andintensity, developing a robust and completeframework will take a long time, delaying thefull gains from private participation.

The high-level dialogue at Jakarta and atregional political forums offers a potential plat-form for launching a comprehensive initiativeaimed at developing a complete framework inall the regionsÕs developing economies within asimilar timeframe. Such a regionwide initiativeis essential if the target of a 30 percent or greaterprivate sector share in infrastructure invesmentis to be met by the end of this century.

To achieve this target, countries need to for-mulate (or clarify) their objectives, strategies, andpriorities for private participation. They need tostreamline internal decisionmaking, develop a

framework for mitigating and sharing risk, andput in place policies and procedures for transpar-ent and competitive bidding and contracting inorder to take advantage of competitive marketforces and reduce transaction costs. And theyneed to redouble efforts to develop domestic bondmarkets and Þnancial instruments to supportlong-term investment in infrastructure projects.

Regional sharing of information and otherforms of cooperation could contribute much tothe initiative. As the trade liberalization initia-tive of Asia-PaciÞc Economic Cooperation(APEC) showed, when economies take parallelor complementary actions in a policy area theycreate important synergies and momentum, andmulticountry initiatives yield economies ofscale. To help maximize the beneÞts for reform-ing economies, countries with more developedmarkets could take steps to promote a greaterßow of private investment and managementskills across the region.

Five sets of actions across the Asia-PaciÞcregion would help create these important syner-gies and ensure the full beneÞts of the reformsfor all economies in the region:

¥ Reorient policies and practices of exportcredit and ofÞcial development agencies todirectly support private projects. In somecases this may require increasing theresources available to these agencies. TheJapanese government has recently made apolicy decision to provide greater support toprivate Þnancing of infrastructure projects inEast Asia and has asked the Japanese Export-Import Bank and Overseas EconomicCooperation Fund to reßect this decision intheir operating strategies. Other industrialeconomies could take similar steps.

¥ Provide a larger volume of political riskinsurance to viable private investments. Asthe Japanese government has recently sug-gested, there is also a need to multi-sourceinsurance and export credit, with greaterinvolvement of agencies from the moreadvanced developing countries.

¥ Remove regulatory barriers and other disin-centives to investment by infrastructureproviders and institutional investors in theregion in otherwise creditworthy infrastruc-ture projects.


Box 1.11 The role of multilateral agencies inpromoting private participation in infrastructure

Many participants at the Jakarta seminar believed that theWorld Bank and other multilateral institutions also have acrucial role to play in bringing about a sharp increase in pri-vate participation. They proposed that this role focus on:

• Supporting continued public-private dialogue atboth the country and the regional level.

• Sharing information and lessons of experiencefrom within and outside the region.

• Helping countries develop a more conduciveframework for private participation.

• Formulating standards for bidding and contractualdocuments.

• Supporting the development of new financingmechanisms and the design of a policy frameworkfor domestic financial sector development, includ-ing bond markets.

• Financing more privately sponsored projects in away that maximizes the leveraging of Bank com-mitments.

¥ Provide more technical assistance (throughgrant funds and expertise) to the developingeconomies for policy reforms and institu-tional development.

¥ Share information and lessons of experiencein both industrial and developing economiesand foster public-private dialogue throughthe regional forumsÑAPEC, the Associationof South-East Asian Nations (ASEAN), andthe Asia, Europe, and Mediterranean (ASEM)association.

What follows

The chapters in this volume discuss the issues ofprivate provision of infrastructure from the per-spective of practitioners and policymakers deeplyengaged in them. Chapter 2, by Donald Russell,describes the experience of Australia in designinga reform strategy and making the transition froman incremental, project-speciÞc approach to moreambitious structural change. This experienceshows how a move to sectorwide reform, withbroad competition and clear rules of the game, canreduce the need for project-speciÞc guaranteesand stimulate active interest among privateinvestors, with substantial gains for the treasury.

Chapter 3, by Yahya Yaacob and G. Naidu,uses the experience of Malaysia as the basis fora discussion of the choices and tradeoffs in dif-ferent methods of contracting with the privatesector. Contracting has become a central featureof the current phase in private delivery of infra-structure and will always be important in areaswhere a competitive model of delivery is not fea-sible. Malaysia has pursued a relatively man-aged approach to contracting, in contrast to thecompetitive model increasingly used in othercountries.

The Chilean experience, discussed in chapter 4by Alejandro Jadresic, demonstrates the centralimportance of a regulatory structure and the com-mitment required to establish such a structure.Like Australia, Chile has been able to curtail gov-ernment guarantees by creating regulated marketsin which contracting parties reach outcomes in linewith commercial principles. The chapter also dis-cusses how Chile has dealt with major societal con-cerns, including environmental issues and theprovision of infrastructure services to the poor.

The discussion on regulation is continued ina thematic chapter by Bradford Gentry on envi-ronmental and resettlement issues in infrastruc-ture projects (chapter 5). These issues are clearlyof great importance to society, and they havealso become key risk factors for private devel-opers and investors. The chapter shows that it isbest to make resolving environmental and reset-tlement concerns an integral part of the projectcycle. The Þnal chapter, by Montek Ahluwalia,discusses a broad range of Þnancing questions,focusing on risks associated with infrastructureprovision and drawing especially on examplesfrom India.

Notes

1. The focus here is on international financingbecause consistent data across countries and over timehave recently become available, while comparable dataon domestic financing of infrastructure are not yetavailable. The reader is thus cautioned that the picturepresented is incomplete. While the intercountry com-parisons and trends are broadly indicative of overallfinancing patterns, they may be less useful for coun-tries such as Malaysia and Thailand, where there hasbeen signiÞcant domestic Þnancing of infrastructure.

2. The data here on international infrastructureÞnancing cover closed and signed transactions of inter-national loans and bond and equity issues reported bycapital market sources. The data have been providedby the World BankÕs International EconomicsDepartment.

3. This section draws on World Bank 1996.

References

Eichengreen, Barry. 1996. ÒFinancing Infrastructure inDeveloping Countries: Lessons from the RailwayAge.Ó In Ashoka Mody, ed., Infrastructure Delivery:Private Initiative and the Public Good. EDIDevelopment Studies. Washington, D.C.: WorldBank.

Kohli, Harinder. 1995. ÒInfrastructure Development inEast Asia and PaciÞc: Towards a New Public-PrivatePartnership.Ó World Bank, East Asia and Pacific,OfÞce of the Vice President, Washington, D.C.

ÑÑÑ. 1997. ÒDeveloping Infrastructure for the NewEast Asia: Forging a Public-Private Partnership.Ó InInternational Chamber of Commerce, Building theNew Asia.

Kwong, Sunny Kai-Sun. 1997. ÒHong Kong: PrivateParticipation with Strong Government Control.Ó InAshoka Mody, ed., The Untold Story: Infrastructure


Strategies in East Asia. Washington, D.C.: EconomicDevelopment Institute, World Bank.

Mikesell, Deborah Newitter. 1997. ÒThe Range ofPrivate Investment in Infrastructure.Ó InfrastructureWorking Group Background Paper. World Bank,DECPI, Washington, D.C.

Naidu, G., and Cassey Lee. 1997. ÒMalaysia: TheTransition to Privatization.Ó In Ashoka Mody, ed.,The Untold Story: Infrastructure Strategies in East Asia.Washington, D.C.: Economic Development Institute,World Bank.

Philippines, Government of. 1995. ÒNew Policy onGuarantees for Private Infrastructure Projects: A

Consultative Document.Ó Manila.World Bank. Asian Bond Markets StudyÑÑÑ. 1994. World Development Report 1994:

Infrastructure for Development. New York: OxfordUniversity Press.

ÑÑÑ. 1995. East Asia Bond Market Study.ÑÑÑ. 1996. ÒFrontiers of the Public-Private Interface

in East AsiaÕs Infrastructure.Ó East Asia and PaciÞcRegional OfÞce, Washington, D.C.

ÑÑÑ. 1997a. Global Development Finance 1997.Washington, D.C.

ÑÑÑ. 1997b. World Development Indicators 1997.Washington, D.C.

Unmet infrastructure needs in East Asiaare constraining both economic growthand social development. Although

spending on infrastructure has increasedsharply in recent decades, it has not kept pacewith demand. Investment in infrastructure rosefrom 3.6 percent of GDP in the 1970s to about 4.6percent of GDP in the 1980s and to about 5.0Ð5.5percent of GDP in 1993, when it reached $70 bil-lion. But to meet investment requirementsÑestimated at $1.3Ð$1.5 billion between 1995 and2004Ñthe investment to GDP ratio will have torise to 6.5Ð7 percent. Past methods of fundinginfrastructure, which depended heavily onexport credit organizations, multilateral lendinginstitutions, and aid agencies, will not be able tofund the required growth. Nor will govern-ments in the region be able to raise the necessaryfunds through tax revenues, borrowing, orincreasing revenues of public utilities.

Given these massive investment needs andthe inability to Þnance them themselves, it is nat-ural that East Asian countries would look to theprivate sector to provide needed capital. Butexperience with the private sector has failed tomeet expectations, raising doubts aboutwhether it can participate in infrastructuredevelopment in a way that leaves countries andtheir communities better off than they otherwisewould have been.

ÒThe original high expectations of the hostcountries and of private sponsors have not beenmetÓ and Òneither the governments nor privatesector are satisÞed with progress,Ó according tothe World Bank (1995). What went wrong?

Experience in the region points to two mainproblems. First, involving the private sector in

infrastructure is more complex than originallythought and requires a level of sophistication onthe part of government that takes time and expe-rience to develop. Second, notwithstanding thestated intention of all governments to involvethe private sector in infrastructure, many gov-ernments are still working through what formthat involvement should take or have reserva-tions about the appropriateness of private sectorinvolvement. Such ambiguity and ambivalenceon the part of government can cloud the truenature of the risks associated with any infra-structure project and lead to long delays in get-ting governments to make key decisions.

This chapter looks at the role of governmentin involving the private sector in infrastructuredevelopment. It draws on experience in theregion, particularly in Australia, to set guidelinesfor government processes and organization.

AustraliaÕs experience with infrastructureprovides some interesting insights. During the1960s Australia invested 9 percent of GDP ininfrastructureÑalmost all of it publiclyfundedÑto meet the post-War surge in immi-gration. Since then the Þgure has fallen to 6 per-cent as a result of a sharp cutback in governmentfunding, but private infrastructure hasexpanded substantially and now accounts forabout 20 percent of total investment. Financialclosings worth $4 billion in private infrastruc-ture were signed in 1995, representing 80 per-cent of private investment in infrastructure inEast Asia.

AustraliaÕs involvement with private infra-structure began around 1987. The federal gov-ernment created an environment thatencouraged development of private infrastruc-

21

Donald Russell

2 Organizing the Government forEfÞcient Private Participation inInfrastructure: Lessons from Australia


ture, but complex federal/state issues havemeant that progress has not been guided by ablueprint from Canberra. Many lessons havebeen learned from this process, and a large pri-vate infrastructure industry has developed inAustralia, backed by a range of institutionalinvestors. Australian design and constructioncompanies, law Þrms, and investment bankshave expanded and used their experience tobuild businesses in East Asia.

The chapter is organized as follows. The Þrstsection lays out the complex issues involved inprivate infrastructure and shows why govern-ment commitment is so important. The secondsection examines the competing interests of thevarious government agencies involved in pri-vate projects and considers the implications forprivate infrastructure. The third section showshow governments try to resolve the problemsraised by the complexity of the issues and thelarge number of agencies involved, and thefourth section suggest how governments mightreorganize to improve private-public coopera-tion and ensure that they obtain the best possi-ble deals. The last section draws lessons from theAustralian experience.

The importance of government commitment

Key decisionmakers in the public sector must beconvinced that private provision of infrastruc-ture makes sense, and they must be willing tofollow through on that commitment. Withoutsuch commitment the contribution of privateinfrastructure to the burgeoning infrastructureneeds of East Asia will be only marginal.Companies involved in the private infrastruc-ture industry typically look for evidence of com-mitment in the following forms:

¥ Willingness of senior ministers and leaders tobe involved in resolving conßicts affectingprojects

¥ Clear signals to government ofÞcials, includingofÞcials of public utilities, that the leadershipwants particular projects to be successfullynegotiated (although not necessarily to theadvantage of particular companies)

¥ Willingness to follow through on other pol-icy matters that ßow from particular privateprojects, such as sectoral plans or frame-

works that give structure to particular pro-jects and reduce risk

¥ Willingness to put in place the distributionfacilities necessary for a private project tosucceed. This is particularly important incountries in which private interests are notpermitted to own distribution facilities.

¥ A track record of successCompanies look for commitment from govern-ment within both the narrow context of formalproject negotiations and the wider context of pri-vate infrastructure policy.

Paradoxically, although the private sector isproviding a growing share of infrastructureinvestment, the governmentÕs responsibility forguiding the process may be greater than it waswhen the system was exclusively public. Thisincreased responsibility stems from the fact thatadding a private component to the systemmakes the system more complex and hencerequires more sophisticated government man-agement.

Variations in the relationship between the publicand private sectors

Private infrastructure projects invariablyinvolve governments at the planning, construc-tion, and operating stages. If a project is part ofa broader public system, such as a toll road, awater treatment facility, or an electricity genera-tor, some public utility or authority will expectthe new facility to Þt comfortably within its sys-tems and planning arrangements. There will bepressure to use similar equipment, compatibletechnology, and existing contractors and to max-imize the value of the public network (existingor planned). From the outset tension will existregarding the exact nature of private sectorinvolvement.

At one extreme the project may be a dis-guised Þnancing arrangement designed toextend a public network without appearing toadd to public sector liabilities. In such arrange-ments the public sector bears all the commercialrisk and guarantees that the revenue connectedto the project will cover the bond holders whoÞnance it. The private sector is responsible forthe design and construction of the project andfor the Þnancing arrangements, which often

Organizing the Government to Facilitate EfÞcient Private Sector Participation in Infrastructure 23

must be innovative if Þnancing is to extendbeyond Þfteen years. The public sector seeks tohave the project built and off its balance sheet toavoid the appearance of incurring new liabili-ties. If the public sector cannot borrow, it seeksto get the project built as cheaply as possible. Ifthe private project is privately operated, there isthe potential for operating efÞciencies andÒbenchmarkingÓ of other parts of the public net-work, something that is often attractive to pub-lic sector managers. At the other extreme, aproject can be completely commercial, with theequity holders bearing full risk and bond hold-ers or commercial banks receiving no guaran-tees. Output carries a market-determined price,and equity holders can reap large returns if theproject is successful or lose their investment ifthe project fails. In between these two extremesthere is scope for different kinds of guaranteesand allocation of risk between the governmentand the private sector.

The importance of the governmentÕs rolecannot be overstated. The government deter-mines the exact nature of the project and must bevery clear about what it is trying to achieve inorder to prevent confusion and frustration on allsides. If, for example, the government wants tonegotiate a deal that is really a disguised Þnanc-ing arrangement but is loathe to provide guar-antees out of concern over its credit standing inthe eyes of the international rating agencies, itcannot expect to negotiate narrow margins onthe Þnancing. Similarly, friction and costly delaywill ensue if private sponsors want to maintainfull commercial control of a project while thegovernment wants it to be part of an existingpublic network.

The nature of the governmentÕs commitment

Governments need to commit to both the con-cept of private infrastructure and to individualprojects. Without a strategy on private sectorparticipation negotiations over individual pro-jects will bog down in confusion. Without a com-mitment to individual projects that Þt into thebroader strategy private sponsors will be unableto wade through the government approvalprocesses.

Negotiations over a take-or-pay contract, for

example, will normally be complex and drawnout. Such contracts are used when private infra-structure augments a public utility network. Insuch circumstances the public utility purchasesthe output of the private project. The viabilityand attractiveness of the project will be deter-mined by the nature and robustness of the con-tractual relationship between the project and thegovernment, and enormous effort will go intonegotiating this contract.

All investment decisions by the private sec-tor involve government approval processes tosome extent, but private infrastructure projectsare in a class of their own because of their longlives, their potential for abuse of market power,and the long tradition in many countries of util-ities serving a social as well as an economic func-tion. The private sector will have to comply witha wide range of government approval proce-dures, involving foreign investment regulationsand exchange controls, export and import con-trols, environment and zoning regulations, thesourcing of equipment and other inputs, andlocal employment requirements.

Case studies from Australia

The Australian experience illustrates the impor-tance of government commitment and the waygovernment commitment develops. In the mid-1980s Australia went through a process of eco-nomic adjustment, brought about by the need tointernationalize the economy and cut back onoverseas borrowings. The federal governmentreduced government outlays to create a budgetsurplus and cut back on the ability of state gov-ernments to borrow. As a result both state gov-ernments and the federal government found itdifÞcult to fund new infrastructure projects. Asthe 1980s progressed the need to Þnance newinfrastructure became more pressing, and thefederal government created a framework withinwhich the private sector could fund projectsviewed as commercially viable. Part of thisframework provided for the privatization ofgovernment assets at both the federal and statelevels. Cutbacks in federal government fundingput pressure on the states to run their govern-ment enterprises and utilities efÞciently and toconsider selling assets.


The federal government went out of its wayto facilitate private involvement in infrastruc-ture and the privatization of assets through arange of incentives. It had no direct control overhow states took advantage of the changed envi-ronment, however, and each state approachedthe task differently and with different motives.As a result Australia has experienced a widerange of outcomes with private infrastructuresince 1987, when the process Þrst gainedmomentum:

¥ Negotiations over a take-or-pay contract foran electricity generator at Loy Yang B inVictoria were drawn out and very expensive.

¥ Construction of a 600-megawatt power sta-tion in Collie in Western Australia was can-celed after lengthy negotiations with privateconsortia.

¥ Private toll roads were constructed in NewSouth Wales and Victoria.

¥ Water treatment facilities in New SouthWales and Victoria were constructed, andmore such projects are under considerationin South Australia.

¥ A tunnel under Sydney Harbour was con-structed in a deal that appears to have beenclose to a disguised Þnancing transaction.Australia has also seen the development of a

range of clear policy structures that haveevolved as a result of this diverse experience:

¥ Following the difÞculties of the Loy Yang Bnegotiations, Victoria deregulated its powerindustry by separating and selling off gener-ators and distributors. The competitiveframework has been so successful thatVictoria has attracted a new range of long-term private investors willing to fund theelectricity industry at very narrow marginsand pay very high prices for assets.

¥ A national electricity grid is in train that willlead to the competitive supply of electricityacross states. Third-party access arrange-ments are being put in place to facilitatedevelopment of a national gas market.

¥ State government utilities will be broughtunder the authority of the national competi-tion regulator, which will prevent them fromserving as revenue-raising devices for stategovernments and force them to compete.

¥ Governments have created an investment cli-

mate that is now sufÞciently attractive andstable that investment banks and other insti-tutions are setting up private infrastructurefunds to channel long-term Þnance intoinfrastructure projects.

¥ A framework for involving the private sectorin water has been developed in SouthAustralia that keeps rates under governmentcontrol but has the private sector managingthe system.

Involving the private sector in the power indus-try. In 1991 the government of Victoria decidedto sell the unÞnished Loy Yang B power stationand commenced negotiations with MissionEnergy, the entity Southern California Edisonuses to conduct business outside its traditionaloperations in the United States. Severe bud-getary difÞculties brought about by extensivelosses sustained by its government-ownedbank, the State Bank of Victoria, and other pres-sures meant that the state government wasunable to fund completion of the power station.Partial sale of the unÞnished power station wasseen as the only way of completing construction.Selling Loy Yang B to a private operator andÒbenchmarkingÓ other generators against itsperformance was expected to raise efÞciencyand improve industrial relations at other gener-ators in the La Trobe Valley. In fact, industrialrelations did improve dramatically, and theintroduction of a private operator enabled theindustry to revise consumer pricing to betterreßect costs.

Sale of the plant was legally complex andexpensive, and the scope for misunderstandingand suspicion was broad. The sale was com-pleted by a new state government, elected in1992, that accepted the basic approach of the pre-vious government although it allowed MissionEnergy to purchase 51 percent instead of the 40percent offered by the previous government(box 2.1).

The sale of Loy Yang B was completed whilethe newly elected state government was in theinitial stages of deregulating the electricityindustry, which could have involved the break-ing up or privatization of the state-owned powerutility, the SECV. Some ßexibility in the take-or-pay contract was necessary to allow for future


deregulation, a development that concernedMission Energy and terriÞed the Australianbanks. In the end, the contract was signed andthe sale was completed, although the contractwas lengthened considerably to build in ßexi-bility. The Victorian Government eventuallybroke up the electricity industry and put a com-petitive structure in place with industry speciÞclegislation (box 2.2). The sale of Loy Yang B toMission Energy did not Þt into the competitivestructure subsequently established. By passinglegislation, the Victorian government could eas-ily have changed the nature of Mission EnergyÕs

investment. They chose not to do so, however,and the legislation effectively puts a fencearound Loy Yang B. The importance of this deci-sion by the Victorian government was not lost onthe industry or the Australian banks that hadfought so hard to obtain guarantees from thegovernment covering the impact of deregula-tion in the Þnal stages of the negotiations.

By its decision the Victorian government sig-naled that it was more interested in maintaininga good investment climate in Victoria than over-riding the earlier agreement, even though itmeant compromising on its competitive objec-tives. With a large privatization program at stakeit was clear where the Victorian Governmentthought its real interests lay.

Having watched this experience, theAustralian banks are now less insistent on stateguarantees, realizing that at the end of the daygovernments have considerable scope to act uni-laterally and that a governmentÕs commitmentto a policy framework is very important.

Box 2.1 Allocating risks in the sale of Loy Yang B

Loy Yang B is a 1,000-megawatt plant made up of two 500-megawatt units. The state government of Victoria offered forsale a 51 percent share of a $2.4 billion asset. The authori-ties had to recover the cost of the plant’s construction, andbidding took place on the basis of the electricity tariff. Theauthorities entered into a thirty-three-year take-or-pay con-tract; financing was arranged by a consortium of institutionsled by two Australian banks. The take-or-pay contractinvolved a capability charge to cover fixed costs and anenergy charge to cover variable costs, such as coal andwater. The security of the financing rested on the perceivedsecurity of the take-or-pay contract, and the banks examinedthat contract carefully.

The state government utility, the State ElectricityCommission of Victoria (SECV), took on the constructionrisk of completing the power station. The SECV was able tolock in the electricity tariff for ten years by hedging its powerprice through interest rate swaps to cover changes to thecapability charge brought about by fluctuations in interestrates.

Mission Energy reportedly incurred costs of about $A50million negotiating the purchase. The costs of the sale to thestate of Victoria were estimated by the State Auditor-General at $A86.7 million:

Cost of sale of Loy Yang B to state government

Amount(in $A million)

Costs to the SECVLegal and other costs 23.2Forgone delayed settlement 7.6Stamp duty paid on behalf of Mission Energy 6.2Total cost to SECV 37.0

Costs to governmentForgone stamp duty 49.7Total 86.7

Note: $A1=$0.78.Source: State Auditor-General estimates.

Box 2.2 Breaking up the electricity industry in Victoriaand creating a competitive market for electricity

After the sale of Loy Yang B in December 1992 the Victoriangovernment revamped the electricity industry, which nowconsists of the following components:

• Five competitive, independently operating gener-ating companies (three brown coal, one gas, andone hydro), two of which have been sold andthree of which are being prepared for sale

• A publicly owned transmission company, PowerNet Victoria, which owns and maintains the high-voltage grid

• A power exchange, which uses the transmissiongrid and which is responsible for the wholesalemarket arranging dispatch and system security. Thepower exchange is not an arm of the generators,and the wholesale price of electricity varies.

• Five regionally based distribution businesses,which have an initial franchise (to be phased out by2001) in respect of franchise customers but whichare free to contest (along with independent retail-ers from other states) business within each other’sregion for nonfranchise customers. Under the cur-rent system nonfranchise customers are cus-tomers who use more than 750 megawatts a yearand therefore are free to choose their distributor.Eventually all customers will have the right tochoose their supplier.


The difÞcult negotiations associated with thesale of Loy Yang B did not lead to the establish-ment of simpler processes for the construction ofthe Collie project in Western Australia (box 2.3).Unlike the Victorians, who concluded that it wasimportant to establish a framework to guide pri-vate sector involvement, the West Australiansapproached Collie as a one-time set of negotia-tions. In the end the project was canceled.

The original proposal was recognized as hav-ing been too large. In addition, Òthe Þnancierswere quite naive in dealing with Government...[and] seemed to be unaware of the process ofgovernment and the Parliament,Ó according tothe Western Australian Minister for Energy. Thegovernment was also critical of the escalatingcost of the original contract and the structuringof the electricity price, which kept prices highuntil 2013, fourteen years after the plant started

generating. The banking industry rejected the claim that

the banks had been unwilling to assume theirshare of the risks, claiming that the cancellationof Collie was not a failure of the infrastructureindustry but a failure for Australia. It called forgreater transparency from government in thedecisionmaking and tendering process.

The cancellation of Collie and the difÞcultiesin negotiating the Loy Yang B deal have led to ageneral realization that large privately ownedgenerators are difÞcult to incorporate into a ver-tically integrated publicly owned electricity sys-tem. To involve the private sector, governmentsneed to be clear about what they are doing andidentify the relationship they want the privategenerator to have with the public utility andwith customers.

Outcomes in electricity have been quite dif-ferent in eastern and western Australia. In thewest cancellation of a build-own-operatescheme appears to have entrenched the power of

Box 2.3 Mishandling award of the Collie power sta-tion contract

In 1989 the Western Australian government called forworldwide expressions of interest in building a 600-megawatt project on the Collie coal fields. The Collie pro-posal came from a plan drawn up in the 1970s as part of thelong-term strategy of the vertically integrated public utility,the State Electricity Commission (SEC). Forty-four firmsresponded to the request for proposals and two final bid-ders—Asea Brown Boveri and a joint venture of Mitsubishiand Transfield, an Australian construction company—wereselected.

In March 1991 Mitsubishi/Transfield was awarded thecontract and set about creating a build-own-operate project.Westpac, an Australian bank, led the financing syndicate.

By April 1992 the first Collie proposal had fallen by thewayside, and Asea Brown Boveri (ABB) replacedTransfield/Mitsubishi, with ANZ Bank leading the financingsyndicate. In September 1992 ABB submitted a new pro-posal that contained large cost increases and some condi-tions that were unacceptable to the government. InFebruary 1993 a new state government was elected thatcontinued to negotiate with ABB, with the power purchaseagreement the main issue. Amid heated debate the newgovernment canceled the Collie project in July 1993. In itsplace the government announced a plan for a 300-megawattsingle unit power station that would be funded and ownedby the SEC but operated by a private company.

Cancellation of the original 600-megawatt Collie pro-ject left the private sponsors bitter, although the decision toallow ABB to build the 300-megawatt plant went some wayto smoothing relations between ABB and the government.

Box 2.4 Letting the private sector manage a publiclyowned water system in South Australia

The South Australian government sought private sector par-ticipation in the water industry in order to improve the effi-ciency of the industry and to build a competitive waterindustry in South Australia capable of winning contracts inEast Asia.

The successful contractor, United Water, a consortiumof Compagnie Generale des Eaux, Thames Water, andKinhill Engineers of South Australia, committed itself to a 20percent cost reduction and to $A628 million exports tooverseas and interstate markets for the ten years beginningin 1996. Under the terms of the 15.5-year contract, UnitedWater manages, operates, and maintains the water andwastewater system for Adelaide, a city of 1.2 million. Thegovernment continues to own the assets and sets prices tocustomers. The government therefore continues to shoul-der the responsibility of setting prices in a way that ensuresthat water is used efficiently.

The state utility, South Australian Water, will continue toprovide the full range of water and wastewater services tothe nonmetropolitan areas of South Australia it is in theprocess of having ten BOT plants constructed for this pur-pose. United Water will manage the day-to-day operationsof the water system, put together and manage the capitalinvestment program, and make recommendations on howthe capital program should be financed. Financing the pro-gram could involve new BOT schemes, but final decisionswill be made by the Minister and the state cabinet.


the vertically integrated state utility. In the eastbreaking up the state utility into distributionand generating units and then selling them hasbeen so successful that it has transformed thestateÕs budgetary position and created a newindustry structure with considerable potentialfor efÞciency and lower energy prices. The chal-lenge will be to keep competitive disciplines onthe system and to prevent the distributors andgenerators from colluding. Speedy develop-ment of a competitive national grid will be veryimportant. The success of the Victorian modelhas changed attitudes around the country andthe vertically integrated power utility appears tobe on the wane all over the country.

Involving the private sector in the water indus-try. The water industry has sought private capi-tal both to provide the investment needed toextend and strengthen public networks and toincrease efÞciency by benchmarking of publicfacilities against private sector plants. Privateinvestment has taken the form of build-own-operate (BOO) and build-operate-transfer (BOT)schemes, largely in New South Wales, Victoria,and nonmetropolitan South Australia. Most ofthe schemes have been closer to disguisedÞnancing arrangements than commercial busi-nesses, and the Auditor-General of New SouthWales (1996) has suggested that the returns tothe private equity holders are greater than war-ranted by the risk of the projects. The ProspectWater Filtration Plant, for example, is legallyowned by the private sector, but it is constructedon land owned by Sydney Water, it is dependenton a supply of bulk water from Sydney Water,and Sydney Water is virtually its only customer.The private sector is able to recover from SydneyWater the entire debt and equity capital of theproject in net present value terms, and the pri-vate sectorÕs equity in the project is protected inthe event of default. Public sector negotiatorshave gained more experience since the Prospectdeal was signed, and recent projects have pro-vided returns that are more compatible with thelevel of risk.

The South Australian government has usedthe private sector to increase efÞciency anddevelop the water industry. It is the Þrst stategovernment to hand over management of the

entire water supply of a capital city to a privatecontractor and allow the private sector to bearthe risk of achieving performance targets.

At this stage there is little interest in Australiain selling franchises or handing water chargingover to the private sector. There is enormousinterest in using the private sector to managewater assets and build and own water treatmentfacilities integrated into a broader public system.

Involving the private sector in the transport sec-tor. The Sydney Harbour Tunnel, construction ofwhich began in 1988, was spurred by the federalgovernmentÕs curbing of state borrowings. Thetunnel accelerated the development of a privateinfrastructure industry in Australia and wasinstrumental in ensuring that subsequent roadprojects allocated some risk to the private sectorand were commercial. Today long-term institu-tional investors Þnance private toll roads, whichare listed on the stock exchange.

Because of scrutiny by the Auditor-Generalof New South Wales, the project is now seen asa disguised Þnancing transaction in which thestate bore all of the risks associated with trafÞcßow. The Auditor-General (1994) has, in fact,concluded that for accounting purposes the tun-nel is owned by the state government (box 2.5).

Several pivate toll roads have been con-structed in Sydney and Melbourne (box 2.6), butpolicymakers now have reservations about theappropriateness of private sector involvementin this area.

Concerns center on the difÞculty that the pri-vate sector has in handling network riskÑa riskthat the government is best suited to handlebecause of its planning responsibilities. Afteralmost a decade Australian governments at thestate and federal level are starting to crystallizetheir views on private involvement in trans-portation. There is broad agreement that thereare important efÞciency gains from having theprivate sector bear construction risk and man-age state-owned assets, and a number of stateshave developed imaginative and useful models.One such model is for road maintenance. TheNew South Wales governmentÕs system of con-tracting road maintenance, which is based onachieving particular targets, is the Þrst compre-hensive system of its type in the world.


Contracts will be speciÞed in terms of the con-dition of the road assets over the term of the con-tract rather than in terms of the conventionalmeasures of work, budgets, and speciÞc tasks.The New South Wales system holds out theprospect of having the private sector bear muchof the risk of managing the condition of theroads.

An interesting test of government commit-ment to private sector involvement was the deci-sion to build the Eastern Distributor, whichconnects the center of Sydney to the airport, as aprivate toll road. Construction of the EasternDistributor involves tunneling under the city,which means that it is relatively easy to build tollbooths without disrupting trafÞc ßows. The pro-ject sponsors have agreed to make improve-ments to the roads connecting to the city tunnel,

which will improve toll revenue and trafÞc ßowthrough the city to the airport and through theSydney Harbour Tunnel, which the governmenteffectively owns.

The government is attracted to the idea of aprivate toll road because only private fundingwould allow the project to be built before the2000 Olympics, and the cost of constructing theroad would have absorbed about 31 percent ofthe stateÕs capital and maintenance budget forroads, a heavy burden to Þnance (box 2.7).

The main private rail project underway is theNew Southern Railway, which will linkSydneyÕs extensive rail system to the airport intime for the 2000 Olympics. This will be a BOTproject, but the state will still own the track. Theprivate consortium will own the stations. Mostof the users will not be from the airport, but theairport trafÞc will pay a premium and will makethe project economic. The siting of the stationswas designed to improve the value of govern-ment-owned land. Preliminary scrutiny by theAuditor-General suggests that this project maybe less disadvantageous to the government than

Box 2.5 Disguising a financing transaction as a com-mercial project: The Sydney Harbour Tunnel

Hailed as a commercial private sector project designed torelieve congestion on the Harbour Bridge when it com-menced in January 1988, the Sydney Harbour Tunnel endedup as a disguised financing transaction of the New SouthWales State government.

Finance for the tunnel was raised by the SydneyHarbour Tunnel Company, which issued bonds that werefully underwritten by the private sector. Responsibility for thebonds rests squarely with the state government, however,and revenues from tunnel tolls go to reducing the govern-ment’s liability for the tunnel bonds. For this reason, theAuditor-General of New South Wales (1994) concludedthat for accounting purposes, the tunnel is owned by theRoads and Traffic Authority, a government authority. Thetunnel toll does not cover the interest on the bonds, and thedeficiency is covered by the toll on the Harbour Bridge and,in the first few years, by the state government. Under theoriginal contract the Sydney Harbour Tunnel Company,which technically owns the tunnel, is entitled to a smallreturn that is tied to its maintenance function. There is noeffective return from operation of the tunnel.

The project grew out of federal government restrictionson state borrowing and the need to reduce congestion onthe Harbour Bridge. It sparked the development of someinnovative long-term (twenty-five-year) financing techniquesand helped create a new market for institutional investmentin private infrastructure.

Since the tunnel is effectively government owned, thestate government will benefit from any increase in traffic vol-umes brought about by private investment in the EasternDistributor, which connects with the tunnel.

Box 2.6 Efficiency of private sector ownership oftoll roads: The M5 freeway in Sydney

The M5 freeway in Sydney, which takes traffic from thesouthern freeway, is designed to eventually become part ofan orbital freeway network that takes traffic around the air-port, through the city, under the harbor, and to the North.The freeway comprises M5 Central, which is privatelyowned and was built first; M5 West, which was fundedlargely by taxpayers in New South Wales and is now oper-ating; and M5 East, which is yet to be built but could be eitherpublic or private. The owners of M5 Central have alreadybenefited from the building of M5 West and will benefit evenmore once M5 East opens.

The Auditor-General of New South Wales (1996) haspointed out that exits from the publicly funded M5 West can-not be completed because of the adverse consequences forthe owners of M5 Central. He concludes that an urban tollroad is not designed to efficiently meet the reasonable needsof the motorist but is designed to capture tolls and concludesthat “private sector ownership of toll roads is prima facie lessefficient than public ownership.”

Opinions differ widely on toll roads. Private toll roadsare considered most appropriate where restrictions neednot be put on alternative traffic flows and where there is lessnetwork risk to the private project that the government hasto cover. These conditions tend to be met on toll roads con-nected to bridges and tunnels.


earlier ones.

Federal incentives for Þnancing private infra-structure projects. The federal government didmore to encourage private infrastructure thansimply cut back on the ability of the states to bor-row and cut their revenue grants. It introduceda range of incentives designed to overcomeaspects of the Taxation Act that made it difÞcultto Þnance private projects. Infrastructure bondswere introduced and development allowanceswere provided for select projects. The federalgovernment also took steps to compensate state

governments that sold state enterprises that hadpreviously been exempt from federal income taxbut that lost their exemption when they weresold to the private sector.

The problem caused by the inability of a pri-vate project to offset the losses created in theearly years against other forms of income fortaxation purposes is a serious one. Australia hasstrict rules governing the transferability oflosses between companies, which has meantthat losses from a stand-alone project can be setonly against future income and not against cur-rent income in an associated company. Since

Box 2.7 Getting a better deal: The Eastern Distributor to the airport

Features of Eastern Distributor project

Feature

Government does not contribute to land or ancillary works• The Road Transport Authority (RTA) will be repaid for landacquisition costs

• Southern Cross Drive will be widened to six lanes andGeneral Holmes Drive to eight lanes at no cost to the govern-ment; wider roads will be available to all road users, who neednot use the northbound toll road.• Contractor will accept full risk of construction and trafficusage.

Improvements to public transportation are not limited by the deal• Toll free access is available for government-owned busesproviding public transport.• Development of other road or public transportationoptions is not constrained by the project.• Preferred proposal acknowledges that Eastern Distributorwill be part of the principal north-south road corridor in thisvicinity.• No renegotiation will take place if alternative public trans-port options are developed.• Bus services for local residents will be improved.

Urban amenities will be improved by tunnel• Six-lane tunnel from Moore Park to north of William Streetwill reduce noise and visual impacts, removal of through trafficfrom streets will improve environment and amenity for localresidents, and pedestrian black spot at Taylor Square will beeliminated.

Toll will be collected in one direction only, and improvements willbe made to toll-free routes.

Contrast with previous projects

• Government contributed $225 million to land acquisitionand associated works for the M2 motorway.• RTA purchased land for M5 motorway; cost was convertedinto a land acquisition loan to be repaid by the owners of theM5.

• Traffic usage of Harbour Tunnel is underwritten by the gov-ernment, which provides a guaranteed revenue stream.

• M2 contract calls for renegotiation

• Tolls are collected in both directions on the M2 and M5motorways.

In August 1996 the government of New South Walesannounced that the Eastern Distributor linking Sydney to theairport would be built as a private toll road. The deal appears

to be better structured than earlier toll road projects and paysmore attention to network consequences.

large infrastructure projects tend to incur lossesin the early years and large proÞts in the outyears, not being able to offset losses when theyoccur has made Þnancing private infrastructureprojects more difÞcult and expensive.

Generalized transferability of tax losseswould have been very expensive, however.Instead, the government allowed approved pro-jects to issue infrastructure bonds. The interestpaid on these bonds is nontaxable, which makesthem attractive to tax-paying bodies and allowsthe bonds to pay a signiÞcantly lower rate thanthey otherwise would. To prevent infrastructurebonds from becoming a general subsidy, thegovernment does not allow a project to deductthe interest payments as a business cost, aswould normally be the case. This means thatinfrastructure bonds provide considerable assis-tance to a project in the early years, when it ismaking losses, and offsets this assistance in thelater years, when the project is making proÞtsand cannot deduct interest as an expense. Thenet beneÞt to the project in present value termsis positive. Infrastructure bonds have beenwidely used in the Þnancing of toll roads.

Lessons learned from experience. As their expe-rience has grown, Australian state governmentshave developed clearer ideas about what rolethe private sector can and should play in the pro-vision of infrastructure. Where these ideas havedeveloped most clearly, so, too, has the commit-ment to put them into effect.

There is now wide acceptance that the pri-vate sector can proved several important bene-Þts in the provision of infrastructure:

¥ It can generate investment that would bedelayed if funded publiclyÑor not providedat all. This can have immense beneÞts if inad-equate power, water, roads, and sewerage areconstraining growth. Private funding ofinfrastructure can free up governmentresources for high priority social programs,such as public health and education, whichcould never be Þnanced privately.

¥ It can produce large efÞciency gains if a pri-vate plant is introduced into a public indus-try that has not previously operated oncommercial lines and that has poor staff rela-tions.

¥ It can help a public utility set prices that bet-ter reßect costs. Reaction to an increase in tar-iffs is often more muted if the utility isprivately owned.There is recognition that governments must

know exactly what they are trying to achieve byinvolving the private sector and that they mustexercise disciplined in achieving their goals.This has not always been the case in Australia,where some contracts were poorly structured.However, as governments have developed aclearer idea of what role the private sectorshould play, their capacity to negotiate tighterand better contracts has increased. Consultantsto government have also played a pivotal role inbuilding frameworks and overseeing negotia-tions.

Recognizing the different interests ofdifferent government agencies

Many different government agencies, each withdifferent interests, are involved in infrastructureprojects. Recognizing these interests and estab-lishing clear-cut procedures for implementingprojects is critical. Both public utilities and pri-vate sponsors must deal with a multitude ofgovernment agencies. But the public utility istreated as an insider and is often an effectiveoperator within the government. In contrast, aprivate sponsor is usually treated as an outsiderand lacks allies within the government.

The Þnance department

The Þnance department seeks to minimize pub-lic liabilities. If public funds are to be used, theÞnance department will want as little debt aspossible raised and it will want to see a revenuestream to repay the debt. If the project is to befunded by the private sector, the Þnance depart-ment will not want the government to be drawninto government funding through guarantees tothe project sponsors.

In Australia, as private infrastructure pro-jects have been subjected to greater scrutiny,state treasurers have begun to require that inter-est rate margins properly reßect any govern-ment guarantees or commitments. This reßectsboth the growing sophistication of Þnancial


markets, which have tended to see through dis-guised Þnancing arrangements and attribute lia-bilities back to the government when the publicsector is in fact carrying all the risk, and height-ened public sensitivity about tolls and contractdetails.

The industry department

The industry department seeks to maximizeopportunities for local industry, whether theproject is publicly or privately funded. It willexpect a substantial proportion of the equip-ment used in the project to be manufacturedlocally and will want to see technology transferand a commitment to export. Although theindustry department may be supportive of pri-vate projects, however, private sponsors mayÞnd it difÞcult to comply with all the industryrequirements, particularly if the departmentrequires a high level of offset business.

The employment department

The employment department seeks to maximizeopportunities for local employment. If skilledpersonnel are required, it will expect them to betrained locally, not brought in from overseas.Most private sponsors can make their projectsattractive to the employment ministry by offer-ing to train local residents to assume importantpositions created by the new project. One of theunexpected beneÞts in Australia of replacingstate-owned enterprises with private Þrms hasbeen the opening up of new career opportuni-ties.

The environmental agencies

The environmental agencies will want to mini-mize the detrimental impact of projects on theenvironment. Given the long life of most infra-structure projects, most investors are interestedin minimizing the risk of having to make expen-sive upgrades to environmental standards partway through the life of a plant.

The environmental agency can perform ahelpful role by ensuring that proposed projectsmeet environmental requirements. The agencycan cause confusion if it is not clear at which

level (state, national, or international) responsi-bility for the environment lies, however.

The land acquisition department

Land acquisition can be difÞcult, particularly ifit is left to the private sponsors to purchaserequired parcels of land. The nineteen toll roadprojects currently out for private tender inIndonesia require that the private contractor beresponsible for land acquisition. Whether thisrequirement hampers the projects remains to beseen.

Many projects cannot proceed unless thegovernment provides the land or is willing touse its powers for compulsory acquisition. Butthe department responsible for compulsory landacquisition will be reluctant to use its power toassist a private project.

The public utility

The public utility will try to maintain its centralrole. If the regulatory function has traditionallyresided with the utility or been heavily inßu-enced by it, the utility will resist change, even ifits resistance endangers new private invest-ment. In many cases the public utility will be themost difÞcult institution or agency to deal with,particularly if the utility believes that the privatesector is being involved as a disguised Þnancingvehicle to get a project built. If the governmentalso believes the project is a disguised Þnancingscheme, problems will inevitably arise, unlessthe private sponsors of the project accept the rolethe government assigns them.

Public utilities become concerned whenchange is proposed, and these concerns canmake change difÞcult. For example, if contrac-tual relations are to exist between the public util-ity and the private project, the public utility willwant to maintain maximum control, even if suchcontrol raises the level of risk to the private pro-ject. The utility will often have powerful allies inthis quest to retain control. It will suit the Þnancedepartment, for example, to have all guaranteesprovided by the utility rather than the govern-ment. Retention of such control by the utility canweaken the private project if the Þnancial stand-ing of the utility is unclear, however.


The workforce of the utility will also feelthreatened if it suspects that the private projectis designed to benchmark more efÞcient levels ofstafÞng. Workers and management of the publicutility can be a powerful political force, particu-larly if the utility has a large investment pro-gram. In Australia in the 1980s, for example, thehead of the government-owned telecommunica-tions company often warned cabinet ministersof the impact that a cutback in the agenciesÕ bor-rowing program would have on phone connec-tions and investment in marginal seats held bythe government in Parliament.

Federal/state issues

In a federation each state or provincial govern-ment will want to bring investment and employ-ment to its region and will be distrustful ofnational guidelines. State and provincial gov-ernments will use their ability to withhold plan-ning approvals to leverage their interests.Without coordination there is likely to be dupli-cation of approvals processes. If a project can besited in any of a number of states, the projectsponsor can use the resulting competitionamong states to negotiate a better deal. Statecharges and taxes can be bid away in thisprocess, and duplication of approval processesdiminished.

Federal/state relations can often be perplex-ing to private sponsors, who may be unsureabout who has Þnal authority and what the realissues are. Matters can become very confusedwhen one level of government assesses a projectdifferently from another and takes policy actionaccordingly. This happened recently inAustralia when the previous federal govern-ment disallowed private toll roads from qualify-ing for infrastructure bonds. The new federalgovernment restored their eligibility.

Public utilities in East Asia are importantbodies overseeing large and expanding invest-ment programs. In 1993 an estimated $70 billionwas spent on investment in the region, most ofit publicly funded. This is quite different fromthe situation in South America, where the pub-lic utilities performed poorly before the recentround of privatizations. In many of the moresuccessful East Asian economies the public util-

ities and authorities are functioning with somecredibility. Cooperation between the ofÞcialsresponsible for key public utilities and the spon-sors of private infrastructure is therefore essen-tial.

Many public utilities and ofÞcials would liketo take advantage of the expanding revenueresulting from economic growth and to imple-ment commercial pricing on their own. If poli-cymakers are not going to fund publicinvestment, they need to make this clear to thepublic utilities by introducing a policy frame-work that deÞnes the role of the private sector.Without clear policy articulation there will beongoing confusion and resistance to change.

Negotiations over take-or-pay or power con-tracts should not be taken over entirely by pub-lic utilities. The minister needs a team aroundhim or her whose experience is broader than thatof the utility. While the governmentÕs negotiat-ing team needs to understand the utilityÕs inter-ests, it also needs to be able to put those interestinto a broader context.

Resolving issues

Handling the competing pressures of privateinfrastructure projects requires that ministers becommitted to private sector participation andput in place administrative arrangements thatallow competing issues to be resolved.

Coordinating government

Private infrastructure projects will stall unlessthe government establishes organizationalstructures to prevent government processesfrom overwhelming projects. Most countries tryto deal with the complexity of the negotiationsand the large number of government agenciesinvolved by establishing central coordinatingagencies. In Malaysia the coordinating agency isthe Privatization Unit of the Economic PlanningUnit (EPU) in the Prime MinisterÕs OfÞce; inAustralia the agency is the OfÞce of Asset Salesin Canberra; in Indonesia the State SecretaryMoerdiono coordinates the processes. The coor-dinating agency in Malaysia is particularly pow-erful, since it comprises the TechnicalCommittee and the Financial Committee, which


evaluate and negotiate with the private Þrms(Yaacob 1996).

A properly functioning central agency can beuseful if it brings all the agencies together andensures that issues are resolved; if the centralagency is just another layer of authority withoutthe ability to deliver decisions from other agen-cies, it will only add to frustration. An all-pow-erful central agency can lead to another range ofproblems if it runs roughshod over other agen-cies without resolving legitimate concerns. Ifthis is done, negotiations can be reopened atgreat cost to all parties.

The process will be most efÞcient if over timean agreed upon framework can evolve thatenables the following key issues to beaddressed:

¥ The relationship between the private facilityand the public utility and distribution system

¥ The tax treatment afforded private projects.While individual tax rulings may be neces-sary, each project should not have to negoti-ate its tax treatment separately. If taxationarrangements are creating problems, theyshould be resolved for all infrastructure pro-jects.

¥ Arrangements for supporting local industry,which should be understood at the outsetand left intact as the tender process proceeds.If local industry preference is part of the ten-der process, it should be transparent.

¥ Requirements for training, environmentclearances, and immigration, which shouldbe understood at the outset.

¥ Authority over and responsibility for theproject, particularly if there is signiÞcantopposition from certain agencies. If senior ministers are Þrm, rules can impose

structure and prevent particular agencies fromconstantly reopening matters and trying toreverse earlier decisions. Establishing a rule thattenders should be evaluated on the basis ofworld pricing of inputs would simplify dealingswith the industry department, for example. Iflocal industry preference is to be built into theprocess, a Þxed level of preference (say, 10 per-cent) can be prescribed. Formalizing this processis preferable to having to make decisions aboutevery potential domestic input. For rules to beeffective, however, senior ministers have to be

able to make decisions on the rules, and the ruleshave to be accepted as Þxed.

Even when rules are established, however,issues will arise that cannot be determined onthe basis of Þxed rules. Some of these issues maybe contentious. But decisionmaking will be sim-pliÞed by establishing rules in advance andleaving commercial judgments to the projectsponsors. Ideally, the sector or regulatory frame-work that the government devises to oversee theindustry will answer most of the questions; astime goes on, the process may require less andless scrutiny. After the initial investment in thedetailed framework, the government may wellÞnd that the process of selecting private infra-structure projects becomes more and morestraightforward.

Both the private sponsors and the govern-ment need to accept a measure of self-discipline;both sides should avoid springing unexpectednew demands on each other once either party islocked into the project. The temptation foreither party to engage in Òsequential ambushÓis real, but the long-run consequences heavilyoutweigh any gains that might be extracted inthe short run. The government must recognizethat it will be seeking new private infrastructurerepeatedly and that a reputation for springingnew demands on project sponsors or changingthe rules when it is very expensive to disengagewill add to Þnancing costs in the future, as spon-sors try to protect themselves against the poten-tially higher cost of doing business. The privatesponsor must recognize that a reputation forbacking out of commitments at the last minute,failing to deliver on promises, or making newdemands will make it very difÞcult to securenew business in the region. The last minutedemand for government guarantees to coverconstruction risk in the Sydney Harbour tunnelproject was difÞcult for the government to han-dle since by then it had no way of withdrawingfrom the project. Governments can protectthemselves by not committing themselves pub-licly to a project until they have reached agree-ment with the main project sponsors on keyissues.

Resolving federal/state disputes


In some countries, particularly those with strongstate or provincial governments, uncoordinatedand possibly confrontational relationshipsbetween policymakers at various levels of gov-ernment may cause problems. When stateadministrations are strong the central govern-ment may feel that it is losing its ability to con-trol the macro economy if many majorinfrastructure projects remain outside its control.To regain control, the central authority will oftenannounce guidelines governing projects. Inmany cases this may make sense, since it is efÞ-cient to have power, water, and transportationconform to national guidelines rather than unco-ordinated state ones. (The Australian experiencewith six noncompatible state rail systems is acase in point.) However, central guidelines cancause problems if the coordination of state andfederal guidelines has not been thought through.

In countries such as China, where the rela-tionship between the center and the provinces isstill evolving, private sponsors of infrastructureprojects often Þnd themselves entangled in com-plex and overlapping administrative arrange-ments. Individual states and cities can haveconsiderable power to raise revenue and fundparticular projects, but the central authority usu-ally has sufÞcient power over taxation orexchange control to exert its authority if itwishes to do so.

Some promoters of private infrastructurehave tried to minimize the difÞculties that canoccur by establishing direct commercial linkswith cities and states (box 2.8). While such a strat-egy may work for certain projects, particularlythose that are commercial and not dependent onmultilateral or aid agencies, it can add anotherelement of risk to the project if the sponsor doesnot fully understand the relationship with thecenter. Without central government involvementand support there is also greater risk associatedwith enforcing contract provisions.

Regardless of a projectÕs ability to dealdirectly with a city or state, there may well be aneed for the central authorities to control behav-ior at the state level, especially when it comes toland acquisition and the provision of state ser-vices to the project. The central authorities mayhave to use their taxation powers and controlson borrowing and foreign exchange to prevent

the project from being held hostage at the statelevel.

In Australia experience has shown that in afederal system in which the states have consid-erable power, heavyhandedness is counterpro-ductive. The federal government needs clearinstruments it can use to enforce its policies, butat the end of the day there has to be a measureof cooperation. In Australia this cooperation hascome from regular formal high-level meetingsbetween state and federal leaders, who havemanaged to agree on a range of national priori-ties they are willing to support. The Council ofAustralian governments (COAG), a body set upto deal with federal/state issues of nationalimportance, meets regularly.

With national agreement has come a willing-ness to coordinate responses to infrastructureprojects, particularly on environmental issues,where effort has been made to avoid duplicatingenvironmental impact studies. Federal programsthat provide for taxation incentives, such as infra-structure bonds and investment allowances foreligible infrastructure projects, have also encour-aged the states to coordinate their processes withfederal processes in order to make infrastructureprojects eligible for federal incentives. As withmost federal systems, there is scope for nationalcoordination, but it is normally the federal gov-ernment that has to pay to achieve it.

If there is a lesson to be drawn from theAustralian experience with federal/state issues,it is that the federal taxation power is veryimportant in building national responses. Thislesson may have some relevance for countriessuch as China, where national/provincial rela-tions are still evolving. The fact that Beijing isbuilding a national taxation base to replace theincome it received from public enterprises willchange the relationship between the center andthe provinces and may result in a steady increasein BeijingÕs authority over the provinces.

Obtaining the best deal

East Asian countries face tremendous opportu-nities for harnessing the private sector. Privatesector investment in infrastructure can removebottlenecks, improve economic growth, andreduce the social problems brought on by inad-


equate water, sewerage, transportation andpower. The private sector is keen to invest andwill accept narrow margins if private Þrms areforced to compete. To negotiate effectively withprivate Þrms however, government agenciesmay need to acquire new skills. Multilateralbodies and multicountry forums can help.

Scrutinizing projects

The potential gains from shrewd contract nego-tiation are enormous in twenty- to thirty-yeartake-or-pay contracts. These contracts are com-plex, legally dense documents the main purposeof which is to provide sufÞcient security to anincome ßow that Þnanciers will lend to the pro-ject. Both the governments and the project spon-sor and Þnanciers will have expert advisorsreview the contract. These advisers will be verybusy during negotiations (although the fact thattheir compensation depends on the amount oftime spent suggests that in some cases negotia-tions may be prolonged unnecessarily).

While governments need advice on the com-plexity of the contracts, they also need the exper-tise to evaluate the broader ramiÞcations of theproject. With toll roads consideration has to be

given to how competitive forms of transporta-tion will interact. Future public investment in thenetwork, which will affect the revenue of the tollroad, also needs to be reßected in the negotia-tions. A new private water treatment plant needsto be coordinated with future public investmentin distribution. A new private power generatorrequires investment in high-voltage and low-voltage distribution facilities to make best use ofthe private project. Future investment by thepublic sector made necessary by a private projectshould be reßected in the negotiations with theprivate sponsors, particularly if the privateequity holders will beneÞt from future publicinvestment. For example, a private toll road maybe very ÒbankableÓ because of its ability to raisea large revenue stream from motorists. But if it isconnecting two toll-free public freeways, legiti-mate questions can be raised as to whether theproject is earning an income stream from the newinvestment or from the existing investment in thetwo public freeways. In such situations closeranalysis might suggest that the public sector jointhe two freeways. Even if the private project rep-resents a disguised Þnancing arrangement andthe public sector beneÞts from commercial wind-falls, all the costs to the public sector associated


The China Water Company is a recently formed developer andinvestor in water supply, wastewater treatment, and water-related infrastructure in China established by AIDC Ltd., anAustralian institutional investor. AIDC’s equity holders are nei-ther suppliers nor operators in the water industry but long-term investors from Hong Kong and institutional investors ofthe Australian and Singapore governments. The company hasinitial shareholder funds of $30 million, shared equally betweenthe AIDC, Hong Kong Land, and Hong Lim Investments, a sub-sidiary of the investment holding company of the Singaporegovernment. Chinese cities appear to see an advantage in deal-ing with long-term investors rather than with operators or sup-pliers who are seen as often being more concerned withshort-run returns.

AIDC is building a commercial business with individualChinese cities and does not deal with concessional lending insti-tutions or multilateral bodies. The company uses appropriatelocal technology where possible and buys its water expertiseon the market. It has entered into a joint venture with theShenyang Water Supply General Company, a government-owned water utility company in Shenyang city, the capital ofLiaoning province. The $25 million joint venture involves theconstruction, operation, and management of water facilities

over a specified contract period. The project is expected to becompleted within eighteen months and will supply 150,000cubic meters of water a day to the local population. The com-pany has also identified a number of other potential projects.

Chinese cities cannot borrow, but their authorities can,although they usually do not have the standing to do so. TheChina Water Company identifies an income stream; negotiatesa contract with the water authority and the city, possibly involv-ing a subsidy from the city; satisfies itself of the security of thearrangements; and builds the facility.

AIDC has found that avoiding aid agencies and multilaterallending institutions has made decisionmaking easier, and it hasfound the Chinese legal structure better than expected. Thecompany has scope to expand, as many Chinese cities nowhave the income and wealth to finance water infrastructure ona commercial basis. It is estimated that to alleviate shortagesChina will need to build more than 230 new water plants sim-ilar in size to the Shenyang project over the next five years.Beijing’s restriction that the private sector cannot own thewater distribution system means that China’s cities will be keento use private capital to fund water treatment facilities to freeup resources to improve distribution.

Box 2.8 Forging links with cities: The China Water Company

with the private project should be considered.Governments sometimes feel more comfort-

able dealing with a business person or companywith whom they have dealt in the past.Negotiations with such a person or companycan often be more straightforward and speedysince there is a greater measure of trust andmutual understanding between the parties.Because they are perceived to have a lower levelof political risk such Òfavored-sonÓ projects cansometimes be Þnanced relatively more simply.In the long run, however, governments are likelyto obtain better terms if they develop a frame-work within which a wide range of companiescan bid on an arms length basis.

Governments are at a disadvantage when aprivate promoter devises a project and then pro-ceeds to market it to the authorities, since thegovernment is forced to depend on the expertiseof the promoter to evaluate the project. Whereproposed projects have been announced by thegovernment and have not been subject to com-petitive tenderingÑas in the Sydney HarbourTunnel projectÑor crucial Þnancial issues havebeen developed in a posttender arrangement,the government faces increased risks. Despitethese drawbacks the Malaysian authorities havedeliberately avoided competitive tendering. Thegovernment selects private companies withwhich it negotiates, and the private sector isencouraged to propose particular projects forprivatization. Contracts in Malaysia have neverbeen regarded as immutable, however, and thegovernment can renegotiate aspects that areunsatisfactory (Yaacob 1996).

Project review: the role of the auditor

In Australia formalized review of the govern-ment contracts with the private sector has beenleft largely to the State Auditor-GeneralÕs OfÞce,which audits projects and makes the Þndingsknown to state parliaments. State Auditors-General are statutory ofÞceholders, andalthough they are appointed by executive gov-ernment their authority comes from Parliament.It is from the Auditors-General in New SouthWales and Victoria that the public knows somuch about the Sydney Harbour Tunnel, thetollways, the water treatment works, and the

costs involved in the sale of Loy Yang B.Partly as a result of the work of the state

Auditor-General, the current government inNew South Wales announced a formal policyentitled ÒGuidelines on Private SectorParticipation in Infrastructure Provision.Ó Theguidelines cover the calling of tenders and themethods of selecting proposals.

The Auditor-General does not have thepower to scrutinize all documents, particularlydocuments held by the private sector, many ofwhich are commercially sensitive. The extent ofthe Auditor-GeneralÕs powers over privateinfrastructure is still being debated in Australia,and some balance will need to be struck betweenprotecting commercially sensitive documents ofprivate companies and taxpayersÕ right to knowwhat is being done in their name.

The role of the regulatory authority

What happens if performance turns out to beradically different from what the Þnancial mod-eling suggested? If the project generates morerevenue than expectedÑbecause of greater pro-ductivity or lower costsÑthere will be politicalpressure to recoup some of the windfall gains forconsumers. If rates of return are lower thanexpected, the project owners will want to revisitthe pricing arrangements, something that gov-ernments usually resist.

In industrial economies governments estab-lish independent regulators to deal with suchsituations. This would be done either by review-ing rates of return or by reviewing CPI-X for-mulae at periodic intervals to keep a balancebetween the interests of the consumers and theprivate investors.

As East Asian economies develop and theprivate sector plays a larger role in the provisionof infrastructure, the need will grow to requirethe review of tariffs in order to avoid abuse ofmarket power. Arbitrary government discretionto adjust tariffs after contracts have been signedwould make private infrastructure projectsmore difÞcult to Þnance on a project Þnancebasis. Establishing a review process withaccepted guidelines and methods of operationcould reduce uncertainty and facilitate new pri-vate investment. In many jurisdictions the


authorities retain the right to reopen contractsthat prove to have undesirable consequences. InMalaysia, for example, the authorities havemade it clear that contracts are not immutable,and contracts have been renegotiated. Such asystem works in Malaysia because there is closecommunication between the government andprivate investors and because investors havebeen allowed to earn attractive rates of return. Inthe power sector Independent Power Producers(IPPs) earn rates of return of 18Ð19 percent, andconcession contracts for road projects aredesigned to provide investors with a return of14Ð15 percent. However, East Asian govern-ments may Þnd it attractive to formalize infor-mal review processes as contracts take ongreater weight and they seek to strike even morecompetitive deals with private investors.

In Australia the current negotiations over athird-party access code for national gaspipelines illustrate how regulatory arrange-ments that open up new markets and providefor a fair rate of return on assets and periodicreview can reduce uncertainty, encourage com-petition, and make private investment moreattractive (box 2.9).

The Þrst private project can act as a catalystto regulatory change. The sale of Loy Yang Bbroke the mold in Victoria, and although it didnot Þt into any competitive model, it did forcethe government to think through the implica-tions of a lone private supplier in a vertically

integrated publicly owned electricity industry.Commencement of the Paiton Power

Generating Complex in Indonesia is likely tolead to similar pressures. Already other privateelectricity projects are progressing on the basisof the Paiton contract, saving money and effortby simplifying the negotiating process. The factthat Paiton debt is now rated and trading in NewYork as investment-grade paper represents amajor step forward. As all parties gain experi-ence, then new regulatory arrangements willneed to be put in place to bring greater certaintyto both existing investors and new entrantswhile promoting competition and efÞciency.

Victoria has had great success with a pricingmodel based on splitting off the generators fromthe distribution function and forcing the gener-ators to compete on pricing in a central pool.Elements of such an approach could be usefullyintroduced elsewhere. Malaysia has taken stepsin this direction by selling off a share in TenagaNasional, previously the monopoly supplier ofelectricity in Malaysia. Five independent powerproducers have been allowed to supply electric-ity to Tenaga, with a separate regulatory agencyset up to ensure fair pricing, prevent anticom-petitive behavior, check prudent investment,and ensure safety in the industry. As well as cor-poratizing the old monopoly supplier and mak-ing it more responsive to market forces, thechanges have brought new entities into the sys-tem that over time will serve as benchmarks


As part of the drive to build a competitive national market forelectricity and gas, state and federal leaders in Australia agreedin mid-1995 to create the Gas Reform Task Force. The TaskForce has set about developing a national code for third-partyaccess to all pipelines. It covers both transmission and distribu-tion systems. Federal and state representatives, regulatoryagencies, the gas industry, and major consumers have all beeninvolved.

The code will determine an access reference tariff, whichwill be based on a fair rate of return on assets. This will requirefinancial modeling and careful valuation of assets. Effort hasbeen made to provide incentives for discounts and to avoidpassing on costs if the pipeline is not fully utilized. The naturalmonopoly elements of the gas industry are to be structurallyseparated, and the reference tariff will be adjusted by a CPI-Xformula.

Provision is also made for review of the reference tariff

every five years in order to allow questions of excess or inad-equate profits to be addressed. Not all issues would be subjectto review, however. Structural issues would be set in stone togive certainty to the project but market variable issues, such asdemand, would be reviewed. This provision also enables theCPI-X formula to be reconsidered every five years.

The model strikes a reasonable balance between the needfor certainty and the difficulties associated with locking up thereference price for at least twenty years. The code reduces riskand is welcomed by investors in the gas industry and newinvestors seeking to compete by building new pipelines. Thecode will increase competition, but it will not get in the way ofthe original negotiations that underpinned the financing of thepipeline, since it will apply only to third-party users after thefoundation users and suppliers have signed contracts that makethe pipeline viable.

Box 2.9 Promoting competition and investment in gas with a third-party access code

against which efÞciency can be measured.Pressure will continue to build to make tariffscompetitive. As the system evolves and theindependents become more signiÞcant, thispressure is likely to lead to further regulatoryreform. Malaysia may be inßuenced by thewindfall that Victoria gained from selling assetsand decide that it, too, wants to reap some of thebeneÞts that can come from continuing to dereg-ulate their system and selling off generation anddistribution assets.

Improving public sector technical and negotiatingskills

Public servants often lack technical and negoti-ating skills. The Auditor-General of New SouthWales (1996) has highlighted the question of thecapacity of the public sector to negotiate accept-able arrangements with the private sector:

The public sector typically does not havethe prospect of commercial failure thathelps to motivate the private sector. Andit has not trained its public service todevelop and assess what are often con-ceptually difÞcult arrangements.Moreover, the government does notreward its senior ofÞcers in the sameway to the same extent as does the pri-vate sector. It would thus be surprisingif the governmentÕs senior executive hadthe necessary skills to negotiate a bal-anced deal with the private sector. Andif senior executives in the governmentsector have these skills, they must betempted to seek employment with theprivate sector which actually pays forthese skills.

Contract negotiations are normally based onÞnancial modeling, which attempts to deter-mine the rate of return generated by particulartariff structures. The task for the governmentand project negotiating teams is to arrive at arate of return and a tariff that look reasonable toboth parties and are acceptable to the Þnanciers.

The Þnancial modeling used by the parties iscentral to the negotiations, and it is essential thatthe government be in a position to build its own

model rather than use a noncustomized model ordepend on the model prepared by the projectsponsor. Having the capacity to build a Þnancialmodel and assess models built by others requiresskills that all governments should possess.

It is clear that the public sector in Australiahas been learning from its mistakes and has beendeveloping new skills. It is also clear, however,that to a large extent different infrastructure sec-tors have failed to learn from the mistakes ofother sectors. More can be done so that experi-ence gained in one area of government is quicklypassed on to other areas and so that experiencegained in one country in the region can be trans-ferred to other countries. Advisers with a broadunderstanding of policy are essential to comple-ment the lawyers and advisers. Outside consul-tants to the Victorian government, includingTroughton Swier and Associates and CreditSuisse First Boston, have been at the heart ofelectricity reform there. Advisers can be trainedor hired, and advisers and ofÞcials to couldrotate among East Asian countries.

The advantages of a framework

The Australian experience reveals that a frame-work that sets out how private infrastructureprojects will operate strengthens the hand ofpublic sector negotiators, particularly if theframework promotes competition among theprivate sector bidders. Understanding the oper-ating environment reduces uncertainty, whichwill enable the government to negotiate nar-rower margins with private promoters. If thegovernment structures its framework to pro-mote competition, it can gain an additionaladvantage by forcing private sector sponsorsand investors to bid against each other to furthercompress margins without exposing the gov-ernment or the community to additional liabili-ties or costs.

There is currently no shortage of privateequity willing to invest in infrastructure projectsin East Asia. Large infrastructure funds inter-ested in long-term investment are located inHong Kong and elsewhere, and U.S. utilities arekeen to invest in East Asian infrastructure pro-jects as a way of lifting their overall earningsrate, the domestic part of which is held down by


regulation in the United States. Internationalcompanies that supply equipment for infra-structure projects, particularly power projects,are also keen to become equity partners, andenergy suppliers want to participate in exchangefor long-term contracts. National utility compa-nies, such as Electricit� de France, are also keento invest as part of a national strategy. All thesecompanies recognize that East Asia is the fastest-growing area in the world, that growthprospects are poor in Europe and elsewhere, andthat the margins on their traditional businessesare low. All have come to the conclusion thatinfrastructure investment in East Asia is oneway of pursuing their corporate goals andincreasing earnings. These companies are alsoattracted to spreading their investments acrosscountries to minimize risk so that the investmentinterest is not concentrated in particular coun-tries but is spread across the region.

At the same time, Asian capital markets aredeveloping rapidly, and there is growing scopefor countries to Þnance private projects domes-tically without recourse to foreign capital. Adeveloping domestic capital market is veryimportant because it enables long-term invest-ment and savings to be channeled into privateinfrastructure and allows the projects to beÞnanced in domestic currency, thereby remov-ing exchange rate risk from what are essentiallydomestic investments. The rapid developmentof Australian capital markets since they werederegulated in the 1980s has been very impor-tant in helping to Þnance private infrastructure.

Given the strategic concerns motivatingmany potential investors, governments havescope to extract premiums. In Victoria the stategovernment created a framework that providedfor the separation of the generators from the dis-tributors, but it also provided for the sale of theregionally based distribution businesses and thegenerators. The Þve distributors and two gener-

ators were sold sequentially during the twelvemonths before August 1996. The tenderingprocess raised $A950 millionÐ$A2.4 billion foreach business, for a total of $A13.1 billion fromthe Þve distribution businesses and two genera-tors (table 2.1). At the time of the tenderingprocess, these assets had a book value of about$A6.5 billion.

The bidders were prepared to accept consid-erable commercial risk once they felt the policystructure was secure. The distribution busi-nesses were sold without guarantees, with theunderstanding that the exclusivity of their fran-chise was not watertight and that franchise cus-tomers who could not choose their supplierswould be protected by a CPI-X regime thatwould set maximum uniform retail tariffs. By2001 all customers would be able to choosewhom they purchased electricity from, and theywould be able to choose from a list of indepen-dent retailers that would include retailers fromother states. Choice would be phased in, withthe largest consumers having the opportunity tochoose Þrst.

In reality, each distribution area was rela-tively secure, but the distributors would have tocompete for their larger customers and could nottreat their smaller customers too casually. Whatmade the distribution businesses attractive tothe bidders was the fact that despite the uncer-tainty, the new arrangements provided theopportunity to introduce new technology and toretain the gains that might come from produc-tivity improvements and cost reductions. Whatwas offered provided enough security and busi-ness opportunity to make the distribution busi-ness attractive assets. The generators were soldwithout guarantees, with only the prospect ofselling electricity in a wholesale market in whichgenerators in other states with excess capacitywould compete.

A wider range of equity holders were


Table 2.1 Proceeds from the sale of the distribution businesses and generators in Victoria(millions of Australian dollars)

United Energy Limited Solaris Power Eastern Energy Powercorp Australia Citipower Limited Yallourn Hazelwood

Sale date August 95 October 95 November 95 November 95 November 95 March 96 August 96Book value 944 490 971 1204 693 1,537 700Gross proceeds 1,553 950 2,080 2,150 1,575 2,428 2,350

Note: United Energy Limited, Solaris Power, Eastern Energy, Powercorp Australia, and Citipower Limited are distribution businesses. Yallourn and Hazelwood are powerstations.Source:

involved in the various consortia, including U.S.and U.K. power utilities and Australian super-annuation funds. One of the reasons such highprices were realized was that funds managersbelieved that the electricity industry in Victoriawas an attractive place to invest. This was theturning point and underscores why the saleprocess was so different from the sale process forLoy Yang B. Loy Yang B needed governmentguarantees and took an extended period ofintense negotiations. The Þve distributors andtwo generators were sold within twelve monthswithout guarantees. The difference was theframework and the fact that the distributors hada wider range of commercial opportunitiesbecause they sold directly to customers, unlikeLoy Yang B whose output was sold on a take-or-pay basis to the wholesale pool. The fact that anational electricity grid and a competitive mar-ket for electricity will be functioning within thenext few years has also added new commercialopportunities (see box 2.10 for an example of asale under a competitive and stable marketframework).

The net result of these sales was that the statebudgetary position was transformed and thestate gained new budgetary ßexibility.

East Asian countries could conclude fromthis that they, too, could extract competitiveprices from the private sector if they establishedframeworks that provide less than exclusivefranchises but allow direct sales to customersand genuine commercial opportunities. Inexchange the private sector would accept mech-anisms to protect customers from unfair trading.There need be no government guarantees if inthe process of establishing the framework, theÞnancial position of the various public utilitiescould be adequately scrutinized. If assets werealso sold, East Asian governments could alsoÞnd their budgetary position improved, withgreater scope to channel resources into high pri-ority areas.

The role of multilateral Þnancial institutions

Multilateral Þnancial institutions have tradi-tionally played an important role in the provi-sion of infrastructure in East Asia, providingÞnance, soft loans, and technical assistance.

Today the Þnancing task has become so largethat multilateral Þnancial institutions can playno more than a small role in Þnancing. They can,however, play an important role in strengthen-ing government institutions and their ofÞcialsby providing training and by funding expertadvice. In this way, governments can deal moreeffectively with project sponsors to everyoneÕsadvantage.

Multilateral institutions can also assist somecountries with the tendering process by provid-ing advice and, if asked, assisting in the selectionprocess itself. This role might be helpful in coun-tries that are not accustomed to managing largeinternational tendering processes on an armslength basis. Participation by a multilaterallending institution might spread the ßow ofinformation and help bring the expectations ofall parties into line.

The Asia-PaciÞc Economic Cooperation(APEC) Energy Working Group, which com-prises the United States, Japan, Canada,Australia, and the developing economies of EastAsia, has been active building regional coopera-tion on energy matters. APEC brings a usefulperspective to such issues as trade liberalization,standards, and infrastructure. It provides theleaders of the United States, Japan, and Chinawith the opportunity to develop a commonsense of purpose in a region in which the threepowers have much at stake in building a creativeand practical relationship.

APEC Energy Ministers met in Sydney forthe Þrst time in August 1996, when theyendorsed a work program that will strengthenregional cooperation by, among other things,facilitating the seconding. of regulators andother trained personnel among membereconomies. APEC also has the potential to speeddevelopment of sectoral and regulatory frame-works for energy. Its main strength, however, itis the only vehicle through which a number ofimportant multilateral issues, including envi-ronmental issues, standardization of energyequipment, and security of energy supply, canbe hammered out.

Environmental issues in East Asia need to beaddressed on a multilateral basis. Withoutagreement among nations, individual countriesmay feel free to water down environmental con-


trols in a bid to gain a competitive advantage.With the environmental consequences of onecountryÕs standards likely to affect other coun-tries, there needs to be a venue in which theseissues can be resolved. There may, in fact, be themaking of an agreement under which variouscountries would provide assistance with newcleaner technology and cleaner coal that wouldbeneÞt all concerned. APEC has the potential tobuild the conÞdence and mutual understandingnecessary to make such agreements possible.

The question of the security of energy supplyis at the heart of many investment decisions, andcoordination of electricity generating speciÞca-tions has the potential to save more than $A10billion, according to APEC. The fact that coun-tries such as Indonesia and Australia, with theirlarge energy resources, belong to APEC pro-vides scope for further progress on this issue.

Conclusion

Involving the private sector in the provision ofinfrastructure opens up a wide range of oppor-tunities. With private sector funds governmentscan make essential infrastructure investmentseven if they have limited scope to borrow orraise revenue. But to attract private sector inter-est and ensure that the state gets good value outof the private sector, governments have todevelop sophisticated processes and acquiresophisticated skills. Private investment in infra-structure forces governments to identify and for-

malize arrangements that previously could beleft unspeciÞed when the system was entirelypublicly owned. Learning to develop new sys-tems is not straightforward, and governmentsfrequently make mistakes along the way. Butgovernments learn from their mistakes.

The Australian experience is similar to that ofmany countries in East Asia. Initially, the stimu-lus for private involvement in infrastructurecame from the need to invest despite tight bud-get constraints, and investments in transporta-tion, water, and power projects were little morethan disguised Þnancing transactions designedto get around budget funding problems. Thisphase also saw drawn out negotiations and thecancellation of projects. Although the privateprojects expanded supply, there was a feelingthat governments could have negotiated betterdeals.

In Australia transactions have been leftlargely in the hands of state governments.Progress has been fastest in those sectors inwhich governments have tried to carve out alegitimate role for the private sector. In the stateof Victoria, for example, the breaking up and pri-vatization of transmission, generation, and dis-tribution assets has transformed that stateÕsbudget position and has created a much morecompetitive and responsive industry.

Transportation has experienced a less radicaltransformation, and doubts over the desirabilityof private toll roads remain. But states haveimproved their ability to extract competitive


Hazelwood Power Corporation operates an integrated browncoal mine and a 1,600-megawatt power station located in theLa Trobe Valley. The Corporation was sold August 4, 1996, for$A2.35 billion. It had a book value of about $A700 million, rev-enue of $A255 million in 1995–96, and earnings before inter-est, tax and depreciation of $A115 million. Revenues wereexpected to decline over the next few years, pending the fulloperation of the national market for electricity.

The corporation was bought by the Hazelwood PowerPartnership, a consortium comprising Britain’s largest electric-ity producer, National Power (52 percent), U.S. power com-panies Destec (20 percent) and PacificCorp (19.9 percent), andthe Commonwealth Bank and its funds arm (8 percent).

The high price paid astounded the market. Hazelwood isa thirty-year-old plant, which many observers believed wouldbe uncompetitive and would have to close once Victoria’s elec-

tricity market was deregulated. In fact, the old State ElectricityCommission of Victoria was set to close Hazelwood.Hazelwood’s main attraction is that it should be able to oper-ate as a low-cost base load facility selling into New South Walesand South Australia once the national grid is established.However, it will face fierce competition from New South Walesand Victorian suppliers, who collectively have excess capacity.

The sale underlined that the market will pay a high pre-mium for a commercial opportunity once a competitive andstable market framework is established. The high price wasachieved despite the government’s refusal to allow a majorequity holder in the Yallourn power station, U.K.-basedPowergen, and a member of one of the losing bidders to havea degree of influence over Hazelwood’s management.Powergen withdrew from the consortia.

Box 2.10 Fetching top dollar when a competitive and stable market framework is established: The sale of Hazelwood

bids from the private sector. State Auditors-General have brought public scrutiny to a num-ber of projects, strengthening the hand ofgovernment and narrowing margins. Stateshave improved their ability to work closely witha number of potential contractors and havedeveloped techniques to extract better deals.The fact that equity holders in a number of listedtoll roads have done well has encouraged arange of new institutional investors, which hasfurther strengthened the hand of governments.

Private water projects have developedsteadily, and they, too, have beneÞted from pub-lic scrutiny and the growing number of privateinfrastructure funds. It is likely that the privatesector will provide an important share of newinvestment in water treatment in the future,although there currently appears to be little inter-est in selling concessions or exclusive franchises.

OfÞcials are still digesting the full implica-tions of the recent experience, although somemeasure of consensus has occurred. Many nowrecognize the beneÞts of setting up a competi-tive framework and forcing private investors tobid against one another. There also appears to beagreement that competition and private owner-ship in the power industry can free up budgetresources and improve efÞciency. Better dealscan now be secured in transportation and water,although for many the main attraction of privateinvestment remains budget ßexibility.

Private infrastructure promotes efÞciencybecause it allows private investors to design andorganize investment to minimize ongoing costs.Private investors are less likely overengineer toplants or invest where risk is too high. BeneÞtson this score are likely to be particularly impor-tant where the design of the plant has a largebearing on the cost of ongoing operations andmaintenance.

What implications for East Asia can bedrawn from the Australian experience?

¥ An innovative and ßexible domestic Þnan-cial market is important. Most private infra-structure projects are domestic and need to

be Þnanced in domestic currencies. Onlywhen institutional investors are attracted toprojects can governments negotiate nar-rower margins from private sponsors.Expanding private infrastructure and adeveloping domestic capital market seem togo together.

¥ Private investor interest in infrastructure ishigh, and private sponsors of projects willaccept considerable commercial risk inexchange for commercial opportunity if theybelieve the policy framework is stable.Governments can reap large returns bydeveloping a detailed framework that setsout clearly the role of the private sector.

¥ If governments achieve the right balancebetween security of return and commercialrisk, private sponsors will accept competi-tion without government guarantees.

¥ There is a role for regulatory oversight,which can encourage competition, reduceuncertainty, and encourage new investment.Regulatory oversight is particularly impor-tant in the power industry.

¥ Even if the major objective in involving theprivate sector in infrastructure is to increasebudget ßexibility, governments can stillnegotiate narrower margins by negotiatingwith several project sponsors and increasingpublic scrutiny of negotiated deals.

References

Auditor-General New South Wales. 1994. ÒRoadTransport Authority: Audit of InfrastructureProjects.Ó New South Wales, Australia.

_____. 1996. ÒFinancing Infrastructure: Private Profitsfrom Public Losses.Ó Paper presented to the PublicAccounts Committee, Parliament of New SouthWales, July 31.

World Bank. 1995. ÒInfrastructure Development in EastAsia and Pacific: Towards a New Public-PrivatePartnership.Ó Washington, D.C.: World Bank.

Yaacob, Yahya. 1996. ÒContracting for Private Provisionof Infrastructure: The Malaysian Experience.Ó Paperdelivered at World Bank Conference, September 24,Jakarta.


Until just over a decade ago the provisionof infrastructure in Malaysia was almostentirely the public sectorÕs responsibil-

ity. Infrastructure services were considered fartoo important to be left to the private sector. Andthe Malaysian government, like many others,presumed that the technology and economics ofinfrastructure precluded any substantial role forthe private sector. Because of natural monopo-lies, economies of scale, and externalities in theproduction and distribution of infrastructureservices, infrastructure was considered moresuitable for public provision than for private.

In the mid-1980s the Malaysian governmentinitiated a program of economic liberalizationand deregulation that included a comprehensiveprivatization policy. The policy entailed down-sizing the public sector while expanding oppor-tunities for the private sector. In infrastructurethe opportunities for private sector participationin areas previously the exclusive domain of thegovernment have expanded considerablyÑnotonly through the sale of equity in state enter-prises but also through privately Þnanced devel-opment of new services and facilities.

A shift toward private provision ofinfrastructure

The privatization policy had its origins in themacroeconomic problems Malaysia faced in theearly to mid-1980s. Many of these problemswere, rightly or wrongly, attributed to the gov-ernmentÕs increasing involvement in the econ-omy, largely in pursuit of the objectives of theNew Economic Policy. This extensive interven-

tion in the economy led to a huge increase in thesize of the public sector relative to the economy:the public sector grew from about 29 percent ofGNP in the 1970s to a peak of about 58 percentin 1981. Public enterprises proliferated.

With the large government presence in theeconomy, the public sector deÞcit grew, leadingto a sharp increase in domestic and external bor-rowing. External debt more than quadrupledbetween 1980 and 1985. Compounding this, theinternational recession in the 1980s dampenedMalaysiaÕs export earnings. The looming eco-nomic crisis culminated in a negative growthrate in 1985, the Þrst since independence in 1957.By the late 1970s it was already apparent thatgovernment revenues could not keep pace withthe growing expenditures. It was these circum-stances that prompted the governmentÕs policychanges.

The shift in strategy from public-sector-ledgrowth to private-sector-Þnanced developmentbegan in 1983, when the prime ministerannounced a national policy relating to the con-cept of ÒMalaysia Incorporated.Ó This conceptsees the country as a corporate entity in whichthe government provides the enabling environ-mentÑinfrastructure, deregulation, liberaliza-tion, and macroeconomic managementÑandthe private sector serves as the main engine ofgrowth. This policy marked the beginning ofMalaysiaÕs ambitious program of privatization.The government set out its rationale for privati-zation in Guidelines on Privatisation (Malaysia,Economic Planning Unit 1985). Implementationof the policy is guided by the PrivatisationMasterplan, adopted in 1991 (Malaysia 1991a).

43

Yahya Yaacob and G. Naidu

3 Contracting for Private Provision ofInfrastructure: The Malaysian Experience


The governmentÕs commitment to expandingthe private sectorÕs role in the economy is reit-erated explicitly in its Second OutlinePerspective Plan (Malaysia 1991b). The SeventhMalaysian Plan (1996Ð2000) conÞrms that pri-vatization will be an important means ofachieving the governmentÕs developmentobjectives (Malaysia n.d.). Infrastructure is atthe forefront of the privatization program.

Over the past decade the liberalization andprivatization programs have dramaticallychanged the conditions under which infra-structure services are provided in Malaysia.Private sector provision of infrastructure isextensive, encompassing ports, roads, powerand telecommunications services, urban infra-structure, water supply, sewerage, and evenhydroelectric generation (see appendix table onpage 53). The privatization of state infrastruc-ture companies and the opening of many seg-ments of the sector to private participation haveresulted in an important change in the respec-tive roles of the public and private sectors ininfrastructure development.

This shift is clearly evident in the Þnancingof infrastructure development. Until the FourthMalaysia Plan (1981Ð85) investment in infra-structure in Malaysia was entirely Þnanced bythe public sector. That is no longer the case. Thegrowth in private Þnancing of infrastructurehas been so dramatic since the mid-1980s thatduring 1996Ð2000, coinciding with the SeventhMalaysia Plan, the private sector is actually setto spearhead infrastructure development in thecountry. During the Plan period the private sec-tor is expected to invest 68.3 billion ringgit(RM), three and a half times the RM 19.2 billionthat the public sector plans to spend on infra-structure (table 3.1). Including the resourcesthat the private sector is expected to spend onthe power industry would further increase theshare of private Þnancing in infrastructuredevelopment during the Plan period.

Contracting for private provision ofinfrastructure

The liberalization of entry into infrastructuresectors has not meant free entry: private Þrms

that want to develop or operate infrastructurein Malaysia need government sanction, in theform of a contractual arrangement with thegovernment. Contracting between the publicand private sectors in Malaysia for infrastruc-ture provision, operation, and maintenance hastaken various forms, the main ones being leasesand concession contracts (see appendix table onpage 53).

Leasing

Leasing is commonly used in privatizing stateinfrastructure companies. Under a lease agree-ment a public authority or agency transfers astate enterpriseÕs physical assets to a privateÞrm for a speciÞed period, and the privatecompany is required to purchase outright anymoveable assets of the state enterprise, such asvehicles. The private operator is allowed torecoup its lease paymentsÑwhich usually takethe form of an initial payment and annual pay-mentsÑand operating costs through user feesfor the infrastructure services it provides.Since ownership of the physical assets remainswith the government, the private operatorassumes only operational risks. At the expira-tion of the contract the physical assets revert tothe government.

In Malaysia leasing has been used mostoften in privatizing ports. The facilities atMalaysiaÕs premier terminal, Port Klang, havebeen leased to three port operating companies,and four other ports are also being run by pri-vate companies under leases. Under two otherlease agreements the corporatized railwaycompany is operating the countryÕs rail ser-vices and Malaysia Airports Berhad is operat-ing its airports.

Concessions

By far the largest number of contracts used inthe privatization of infrastructure in Malaysiahave taken the form of concession agreements.Concessions incorporate all the features of alease contract, but from the outset the privatecompany has the additional responsibility ofÞnancing the construction of the project. Thus,

Contracting for Private Provision of Infrastructure 45

unlike leases, which apply to existing assets,concessions are used for the development andoperation of new infrastructure. In a typicalconcession agreement the private Þrm under-takes to Þnance the construction of an infra-structure facility and to operate it for an agreedperiod. Consequently, in a concession agree-ment the private provider in theory assumesboth the operational and the investment risks.

The Malaysian government has used con-cession contracts for the construction and oper-ation of sixteen major urban and interurbanroad schemes, build-operate-transfer (BOT)projects involving a total investment of morethan RM 17 billion. Three light rail transit pro-jects in the capital city of Kuala Lumpur arebeing developed under concession contracts asbuild-operate-own-transfer (BOOT) schemes.Concession contracts have also been used forthe development of new ports in Malaysia, theLumut Maritime Terminal and the PelabuhanTanjung Pelepas.

A variation of the concession is the contrac-tual arrangement under which the independentpower producer projects in Malaysia have beendeveloped. In most countries such projects haveinvolved both a BOT or BOOT concessionagreement between the government and theindependent power producer and a power pur-chase agreement between the producer and the(often integrated) national energy corporation.In Malaysia, however, private power genera-tion has been brought about through theissuance of licenses by the Electricity SupplyDepartment to the independent power pro-ducer Þrms and a power purchase agreementbetween the Þrms and Tenaga Nasional Berhad,the integrated power utility. The reason for thisarrangement was that, from the very beginning,the government did not want to bear any of theproject risks. The power purchase agreementsare therefore the substantive contractual instru-ment in the development of private power gen-eration in Malaysia.

Table 3.1 Public and private financing for infrastructure development in Malaysia, 1991–2000(ringgit millions)

Sixth Malaysia PlanSeventh Malaysia Plan

Sector Allocation Expenditure allocation

Public sectorTransport 12,881.6 11,594.7 15,484.2

Roadsa 8,451.0 7,572.6 9,838.8Rail 1,802.6 1,735.4 3,370.0Ports 434.0 410.9 486.8Airports 1,833.0 1,780.6 1,266.0Urban transport 361.0 95.2 522.6

Utilities 2,876.3 2,796.7 3,687.3Water supply 2,749.5 2,671.9 3,575.3Sewerage 126.8 124.8 l12.0

Communications 76.3 71.0 58.6Telecommunications and postal services 45.0 39.9 25.5Meteorological services 31.1 31.1 33.1

Total 15,834.2 14,462.4 19,230.1

Private sector (privatized projects) InvestmentRoads 17,505.0Ports 4,241.7Airports 5,956.0Telecommunications 25,400.0Postal services 260.0Water supply 2,571.7Sewerage 1,759.4Rail 10,600.0Total 68,293.8

Grand Total 87,523.9

a. Excludes local roads in regional development areas, some local authorities, and agricultural roads, which have been allocated RM 700 million.Source: Malaysia n.d.

Other forms of contracting

Three other contractual arrangements deservemention. The Þrst is a contract between the gov-ernment and a private provider that essentiallycombines a lease and a concession agreement,used in privatizations in which the private com-pany both takes over existing assets and isrequired to develop new facilities. The new ter-minal at Port Klang, Klang Multi Terminal, isone example of such an arrangement. Another isthe privatization agreement between the gov-ernment and the private operator of Johor Port(Seaport Terminal Sdn. Berhad), which consistsof a lease for operating the existing facilities anda concession agreement to build a new port,Pelabuhan Tanjung Pelepas.

Management contracts are another avenuefor involving the private sector in infrastructure.Under a management contract the private con-tractor is responsible only for the operation andmanagement of the government-owned facility.This type of contract is rarely used in MalaysiaÕsinfrastructure sector. The government hassigned a few management contracts in the watersector and a management contract for PenangBridge that obligates the private Þrm to investRM 500 million in improvements and repairs.

In some infrastructure industries the govern-ment issues licenses to private Þrms to provideservices formerly provided exclusively by a gov-ernment department or state enterprise.Privatized ports, for instance, operate under alicense issued by the government, as do TenagaNasional Berhad and Telekom Malaysia. Theselicenses are time-bound and range from twenty-one years for Tenaga Nasional Berhad andTelekom Malaysia to thirty for most of the pri-vatized ports. Licenses issued to private compa-nies to provide telecommunications services arenot time-bound. Although licenses are not in astrict sense contracts, like leases and concessionsthey too cannot be had on demand. They alsoimpose implicit contractual obligations on thelicensees, and failure to fulÞll those obligationscan result in their termination.

Contracting procedures

The procedures used in contracting depend on

who initiates the privatization proposal. InMalaysia a privatization project in infrastructurecan be initiated by either the public or the pri-vate sector. The procedures for awarding con-tracts in these two cases are similar though notidentical.

Projects initiated by the public sector

A privatization proposal initiated by the publicsector can be implemented in one of two ways.The government can choose or nominate a pri-vate company to undertake the project. Or, ifthe government has already undertaken a pri-vatization feasibility study, it can direct thePrivatization Unit of the Economic PlanningUnit to offer the project for direct negotiationwith a selected private company or to call for arestricted tender. The choice of approach and ofthe private contractor (even in the case of arestricted tender) is made at the highest politi-cal level.

The substantive contracting procedure is thesame regardless of how the private contractor ischosen:

¥ The private company (or companies in thecase of a restricted tender) is required toundertake a detailed feasibility study at itsown expense and to prepare a detailed pro-posal.

¥ Two committees established by thePrivatization Unit, the Technical Committeeand the Financial Committee, evaluate thedetailed proposal and undertake negotia-tions with the private Þrm. The committeesthen prepare a joint recommendation andsubmit it to the Economic Planning Unit.

¥ The Economic Planning Unit submits the rec-ommendation to the Cabinet, which eitheraccepts or rejects it.

¥ If accepted in principle by the Cabinet, theprivatization proposal goes through a roundof detailed negotiations between the privatecompany and the relevant ministry.

¥ Upon completion of the negotiations, the pri-vatization proposal is again submitted forapproval by the Cabinet, which even at thispoint may reject it.

¥ If the Cabinet accepts the draft agreement (alease or concession), the ministry and the pri-


vate company enter into a contract.

Projects initiated by the private sector

A unique aspect of MalaysiaÕs privatization pol-icy is that it allowsÑeven encouragesÑthe pri-vate sector to initiate or propose projects forprivatization. In such cases the contractingprocess is initiated by the private ÞrmÕs submis-sion of an unsolicited proposal to the EconomicPlanning Unit. If the initial evaluation Þndsmerit in the proposal, the unit gives the Þrm aletter of intent and the status of Òpreferred con-cessionaire.Ó This process is tantamount to Þrstcome, Þrst served because it very nearly accordsthe company that submits a privatization pro-posal exclusive right to undertake the project.But the company must still prepare and submita detailed project proposal, including a feasibil-ity study, for evaluation by the Technical andFinancial Committees. The project then goesthrough a process similar to that for a proposalinitiated by the public sector.

Basic features of the contracting process

Regardless of how a privatization project is ini-tiated, the contracting process will alwaysinclude certain basic features.

Length of negotiations. The larger the projectand the more technically complex it is, thelonger it takes to negotiate the contract. Mostnegotiations for infrastructure privatization inMalaysia, however, are concluded within sixmonths, and lease contracts take much less timeto conclude than do concessions. (EconomicPlanning Unit ofÞcials are of the view that con-tracting through open, competitive biddingwould take much longer than the sole-sourcenegotiated or restricted tender processes nowused in Malaysia.) Because of the experiencegained by the evaluating agencies and, equallyimportant, by the private sector bidders, con-tracting now is said to take only half as long aswhen the privatization program began.

Critical negotiating points. The most importantnegotiating points in contracting for infrastruc-ture projects relate to technical speciÞcations,

length of contract period, level of user fees (tolls,port fees, power purchase price), service qualitystandards, and government support (supportloans, trafÞc volume supplements for toll roads,external risk supplements, government assis-tance in land acquisition). At the beginning of thecontracting process the distance between thegovernmentÕs position and the private ÞrmÕs isusually quite large. It is during the negotiationsbetween the private Þrm and the Technical andFinancial Committees that compromises aremade and agreement is reached. The initial dif-ferences on nearly all the vital parts of the con-tract are now beginning to narrow, largelybecause both the government (and its agencies)and the private sector have become familiar withthe range of technical and Þnancial elements.

Scope of contract. A typical contract beginswith a section containing the provisions of theconcession agreement. Other important articlesset out the design details for the project, the con-struction schedule, the toll rates or other userfees, the schedule of fee increases, and any gov-ernment support to be provided. The other arti-cles in a typical concession or lease contractpertain to termination of the contract and dis-pute settlement mechanisms.

Evaluation and negotiating mechanism. TheTechnical and Financial Committees are theprincipal government bodies for evaluating pri-vatization proposals and negotiating contractsin Malaysia. Their formation has centralized theevaluation process, facilitating the entire con-tracting process. The effectiveness of the com-mittees depends on the expertise and skills oftheir members. The members of the TechnicalCommittee are drawn from the ministries andgovernment agencies where the expertiseneeded to evaluate a particular proposal is avail-able. Thus for a road project the TechnicalCommittee would include, besides ofÞcials fromthe Privatization Unit, ofÞcials from theInfrastructure Section of the Economic PlanningUnit and engineers from the Public WorksDepartment, the Highway Planning Unit of theMinistry of Works, the Malaysia HighwayAuthority, and the Department of theEnvironment. For an independent power pro-


ducer proposal the committee would includeofÞcials from the Energy Section of theEconomic Planning Unit and the ElectricitySupply Department. In addition to representa-tives from the Privatization Unit, the FinancialCommitteeÕs membership includes staff fromthe Treasury, the Accountant GeneralÕs OfÞce,and the Attorney GeneralÕs OfÞce.

The two committees are also authorized tobegin the negotiating with the private sector.Over time this task has been eased as technicalbenchmarks are established on the basis of ear-lier projects and as the committees gain experi-ence in assessing the technical and Þnancialparameters in the private sector proposal. Thecommittees do not have the Þnal word in nego-tiations. Contracts are Þne-tuned at the Cabinetlevel and even during Þnal negotiations with theministry.

Open bidding or negotiated contracting?

The description of the contracting proceduresabove should make it evident that contracting forinfrastructure privatization projects in Malaysiadoes not occur through transparent and compet-itive bidding. In fact, in the infrastructure priva-tization over the past decade only one contracthas been awarded through competitive bidding(a small independent power producer project inthe state of Sabah). In nearly all other infrastruc-ture privatizationÑwhether through divesti-ture, leases, or concessionsÑcontracting hasbeen through a sole-source negotiated process. Ina very few cases, where the project was identiÞedby the government, contracts were awardedthrough a restricted tender offer. Examplesinclude the Kuantan Port privatization and theEast Coast Highway, for which three Þrms wereinvited to submit tenders.

In both sole-source negotiated contractingand restricted tender offers, the private com-pany has generally been selected by the coun-tryÕs political leader and the basis of selectiontherefore cannot be discerned. Despite the fre-quent criticism that the award of contracts in theinfrastructure sector has lacked transparencyand the accusations of political favoritism, theMalaysian government has rarely deemed it

necessary to explain or justify its choice of con-tracting mechanism or of the Þrm to which acontract has been awarded.

There are three possible explanations of whythe government has avoided competitive bid-ding. The Þrst is a belief that awarding contractsthrough open, competitive bidding involveshigher transaction costs than negotiated con-tracting. A second possible explanation is abelief that open, competitive bidding for con-tracts may make it difÞcult to achieve the NewEconomic Policy objectives. A third possibility isthat the government has avoided open, compet-itive bidding because it is time-consuming.Negotiated deals apparently can be completedin half the time required for a competitive bid-ding process.

Contracting and efÞciency

It could be argued that because contracts forinfrastructure projects in Malaysia have notbeen competitively awarded, some of the poten-tial efÞciency gains from privatization haveinevitably been sacriÞced. Although this maywell be true, MalaysiaÕs approach to contractingincludes features that should offset at least someof the potential efÞciency losses.

Negotiating process

The negotiating mechanism, especially theTechnical and Financial Committees and thePrivatization Unit, appears to function in a waythat ensures that private Þrms cannot dictate theterms of contracts. Both committees have therequisite skills and expertise to undertake effec-tive and meaningful negotiations with privateÞrms, and it is generally agreed that they givetheir best effort to obtain the best possible termsfor the government and the public. That thebureaucracy is a formidable negotiator is con-Þrmed by many of the private Þrms nowinvolved in the infrastructure sector.

There are numerous examples of the bureau-cracyÕs effectiveness in negotiations. In manycases toll rate proposals have been scaled downduring negotiations and lease and concessionperiods have been shortened. The most recent


example is the reduction in the sale price of elec-tricity from the Bakun Dam concession.

One factor that favors the bureaucracy in itsnegotiations with private Þrms is its informationadvantage. Work by government researchdepartments, submissions by other private com-panies for the same project, proposals for similarprojects, and other sources of information pro-duce a huge database that the government canuse to assess and evaluate privatization propos-als. There have been so many road privatizationprojects, for example, that government depart-ments and agencies are sufÞciently well informedto undertake effective negotiations on all sub-stantive issues of a road privatization proposal.

In addition to the bureaucratic scrutiny, thereare at least two other levels of review at whichcontracts can be modiÞed to take into accountefÞciency considerations and consumer inter-ests. The negotiations are subject to scrutiny atthe highest political level of the Cabinet, andcontracts undergo Þnal negotiation at the min-istry level. Both processes help ensure that pro-jects are efÞcient.

SpeciÞcation of evaluation criteria

For all infrastructure sectors open to private sec-tor participation in Malaysia, basic technical andÞnancial standards and design parameters havebeen speciÞed. And regardless of whichapproach has been used to award a contract,these standards must be met by the private sup-plier. For roads, for example, privatization pro-posals must contain a set of technical parametersthat meet the standards for design, constructiontechnology, pavement design, and the like thatare set by the Public Works Department and theHighway Authority. For the Þnancial evaluation,proposals must provide project cost estimates,trafÞc and revenue projections, a Þnancial analy-sis, and a Þnancial plan. These technical andÞnancial criteria provide some assurance that theprojects approved are efÞcient.

Allocation of risks

In the early years of infrastructure privatizationin Malaysia some of the commercial risks of pro-

jects were borne by the government. But manyof these risks have since been shifted to the pri-vate operators. Similarly, forms of governmentsupport once provided to private operators areno longer as readily available.

The experience with road projects illustratesthe shift of the burden to the private sector. Toenhance the viability of road projects, the gov-ernment in the past gave private operators assis-tance in the form of support loans, trafÞc volumeguarantees, and external risk guarantees andbore the full cost of land acquisition. But since1995 the government has begun to transfer moreof the risks in road projects to the private sector,including the cost of land acquisition. (However,the government still gives advances or interest-free loans to concession companies to alleviatethe burden of Þnancing in the early years of theconcession.) The transfer of the cost of landacquisition to the concession companies meansthat they must now be more precise in theirdesign work, resulting in less waste in landintake and thus greater efÞciency.

In the electricity sector too there are signsthat efÞciency is now a greater consideration.The Þrst independent power producer projectwas developed under a take-or-pay power pur-chase agreement providing little incentive forefÞciency. For the next four such projects theagreement did not include take-or-pay provi-sions, so that the most efÞcient power producerwould be the Þrst allowed to supply the grid.Changes have also been made in the pricingmechanism to force power producers toincrease efÞciency. The independent power pro-ducer pass-through in the pricing formula wasdiscontinued, and the automatic rate revisionclauses have been removed from the licensesgranted to privatized utility companies.

The role of consumers

Whatever the mechanism by which the contractwas awarded, privatization projects haveincreasingly had to stand up to scrutiny byMalaysian consumers. On many occasions thepublic has expressed dissatisfaction over the lev-els of toll rates, telephone rates, electricity rates,and fees for sewerage services, forcing the gov-


ernment to renegotiate with the concessionaires.

Factors in the success of contracting inMalaysia

Even if contracting in Malaysia cannot be said toguarantee efÞcient infrastructure provision,there is no doubt that, unlike many other coun-tries, Malaysia has succeeded in attracting sig-niÞcant private resources to its infrastructuresector. In addition to the projects already com-pleted and under way, many proposals areunder consideration for the privatization ofexisting ports, the development of new port ter-minals, the privatization of roads, and the devel-opment of independent power producerprojects.

What explains the governmentÕs success incontracting with private Þrms for the supply ofinfrastructure services? There are three main fac-tors. First, the government has a substantial andcredible commitment to the privatization ofinfrastructure. Second, the government has con-sistently shown a genuine interest in makingprivatization projects succeed even if that meansrenegotiating with the private operators. Andthird, the straightforward institutional structurefor infrastructure privatization and the harness-ing of expertise and skills at the EconomicPlanning Unit to evaluate and negotiate projectproposals have facilitated contracting.

There is strong commitment to the privatiza-tion policy among the countryÕs political leader-ship. Prime Minister MahathirÕs personalinterest in the privatization program lends con-siderable credibility to the policy. The politicalstability and the overwhelming strength of theruling coalition party also help assure the pri-vate sector that the privatization policy and theeconomic liberalization program will be sus-tained. The Guidelines on Privatisation,Privatisation Masterplan, and Second OutlinePerspective Plan all conÞrm the governmentÕscommitment to privatization. The high-levelcommitment creates an environment conduciveto contracting by limiting the governmentÕs abil-ity to behave opportunistically.

The bureaucracyÕs attitude toward the pri-vate sector has become increasingly positivesince the governmentÕs adoption of the Malaysia

Incorporated concept. The public sector is nowencouraged to view the private sector as a part-ner in development and to work to ensure thesuccess of privatization projects. One outcomeof this approach relates to the provision of infor-mation to private Þrms to assist their projectpreparation. Feasibility studies undertaken bythe government or its agencies are now readilymade available to the private Þrms selected tobid for a project, and departments are encour-aged to support the ÞrmsÕ project preparation.

The public sectorÕs commitment to makingprivatization projects succeed is reßected in thegovernmentÕs ßexible approach to implement-ing contracts, best illustrated by projects thatneed to be renegotiated. Contracts have oftenbeen modiÞed by mutual agreement because ofunanticipated eventsÑsometimes to protectgovernment or consumer interests and some-times at the request of the private Þrm. Therehave been at least four major renegotiations inrecent years, and the expeditious settlement ofthe issues reßects both the governmentÕs com-mitment to projectsÕ success and the private sec-torÕs belief that the government is renegotiatingin good faith. The following examples illustratethe ßexible manner in which privatization con-tracts are implemented in the country:

¥ Public protests over the imposition of tolls bythe private developer of an urban road pro-ject in Kuala Lumpur led the government torenegotiate the contract so as to reduce thetolls and delay their imposition.

¥ In the Kelang Container Terminal privatiza-tion agreement the lease contract gave thecompany exclusive rights to provide con-tainer handling services at Port Klang. Soonafter the agreement was signed the govern-ment realized that granting these exclusiverights had been a grave error. When theremaining facilities at Port Klang were leasedto a new port operating company that wasalso allowed to develop its own containerberths, the government persuaded KelangContainer Terminal to drop its exclusiverights. In return the government allowed thecompany to expand its terminal from threecontainer berths to four.

¥ At the beginning of 1996 PLUS, the conces-sion company for the North-South


Expressway, was entitled under the conces-sion contract to raise its toll rates. But thegovernment persuaded the company todelay the toll hikes and reduce the increaseand began negotiating with PLUS the com-pensation for this change to the contract.

¥ As a result of much public dissatisfactionwith the way the national sewerage projectwas being implemented under a concessioncontract with Indah Water Konsortium, thegovernment commenced renegotiation of thecontract.

¥ In 1994 the minister responsible for telecom-munications issued a number of newlicenses. In early 1996, however, the newminister of Energy, Telecommunications, andPost thought that too many licenses had beenissued and encouraged consolidation of theindustry through mergers among the Þrms.The matter is now being left entirely to theprivate sector. These examples suggest that contract rene-

gotiations have been common in Malaysia. Butthey have been neither time-consuming norcostly. The governmentÕs ßexibility has con-tributed to this. In addition, private infrastruc-ture Þrms have been extremely cooperative, inpart because they depend on the goodwill of thegovernment for future projects. Renegotiation isalso eased by the operational auditor system, inwhich one auditor comes from the governmentand the other from the private company. Thissystem minimizes disputes over requests forrenegotiation.

Also important in MalaysiaÕs success in con-tracting out the provision of infrastructure toprivate Þrms is the simple institutional structurecreated to deal with infrastructure privatization.The Privatization Unit and the Technical andFinancial Committees constitute an effectiveand inexpensive contracting mechanism, andthe procedures for gaining approval for privati-zation projects are fairly straightforward. ThePrivatization Unit acts as a one-stop agency,although approval is also needed from theCabinet and the relevant ministries. But thetriple-layered approval system does not appearto be overly cumbersome or complex. Contractdisputes are to be settled by arbitration in accor-dance with the arbitration rules of the United

Nations Commission on International TradeLaw (UNCITRAL). There is no provision forlegal resolution of disputes.

Also contributing to the rapid pace of infra-structure privatization in Malaysia is the rate ofreturn that the government allows private Þrmsto earn from investments in the sector.Independent power producers typically earnreturns of about 18Ð19 percent, and concessioncontracts for road projects are generally tailoredto give investors a return of 14Ð15 percent.

Notes

Yahya Yaacob is the Secretary General of the Ministryof Works of Malaysia, and G. Naidu is an associate pro-fessor at the University of Malaya.

References

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Hitam, Samsudin bin. 1995. ÒTransport Infrastructurefor Economic Development: The Case forMalaysia.Ó Paper presented at the Asian Conferenceon Emerging Role of the State in the TransportSector in the Perspective of EconomicLiberalization, New Delhi.

Ibrahim, Abdul Khalid bin. 1987. ÔÕPrivatisation andthe New Economic Policy.Ó Paper presented at theNational Conference on Privatisation: Towards theFormulation of a Masterplan, ISIS, Malaysia.

Jomo, K.S., Christopher Adam, and WilliamCavendish. 1995. ÒPolicy.Ó In K.S. Jomo, ed.,Privatising Malaysia: Rents, Rhetoric, Realities.Boulder, Colo.: Westview.

Kennedy, Laurel. 1995. ÒTelecommunications.Ó In K.S.Jomo, ed., Privatising Malaysia: Rents, Rhetoric,Realities. Boulder, Colo.: Westview.

Lee, Cassey. 1995. ÒRegulatory Reform in theInfrastructure Sector: The Malaysian Experience.ÓPaper presented at the Regional Workshop onManaging Regulatory Policies and Reforms in EastAsia, Kuala Lumpur, July.

Malaysia. 1991a. Privatization Masterplan. KualaLumpur: National Printing Department.

ÑÑÑ. 1991b. The Second Outline Perspective Plan,1991Ð2000. Kuala Lumpur: National PrintingDepartment.

ÑÑÑ. n.d. Seventh Malaysia Plan (1996-2000). KualaLumpur: National Printing Department.

Malaysia, Economic Planning Unit. 1985. Guidelines onPrivatisation. Prime MinisterÕs Department, Kuala


Lumpur.ÑÑÑ. 1988. ÒNational Ports Plan.Ó Vol. 1,

ÒOverview.Ó Prepared by PRC Engineering, Inc. inassociation with Sepakat Setia Perunding Sdn.Berhad and Aseambankers Malaysia Berhad. KualaLumpur

Malaysian Economic Association. 1991. ÒBintulu PortPrivatization Study.Ó Vol. 1.

Naidu, G. 1992. ÒPrivate Provision of PhysicalInfrastructure: The Malaysian Experience.ÓEconomic Development Institute Working Paper.World Bank, Washington, D.C.

ÑÑÑ. 1995. ÒInfrastructure.Ó In K.S. Jomo, ed.,Privatising Malaysia: Rents, Rhetoric, Realities.Boulder, Colo.: Westview.

Naidu, G., and Cassey Lee. 1997. ÒMalaysia: TheTransition to Privatization.Ó In Ashoka Mody, ed.,The Untold Story: Infrastructure Strategies in East Asia.Washington, D.C.: Economic Development Institute,The World Bank.

Ng, Chee Yuen, and Toh Kin Woon. 1992.ÒPrivatization in the Asian-Pacific Region.Ó AsianPaciÞc Economic Literature 6(2).

Puthucheary, Mavis. 1987. ÒAn Assessment of thePrivatization Guidelines with Reference to ObjectiveSetting.ÕÕ Paper presented at the NationalConference on Privatization: Towards theFormulation of a Masterplan, ISIS, Malaysia.

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Mokhtar Tamin, eds., The Malaysian Economy inTransition. Tokyo: Institute of DevelopingEconomies.

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Appendix table Infrastructure privatization and contracting in Malaysia

Sector and project Method of privatization Type of contract

PortsKlang Port

Kelang Container Terminal Sale of equity (1986) Lease (21 + 30 years)Kelang Port Management Sale of equity (1992) Lease (30 + 30 years)Klang Multi Terminal Sale of equity and BOT (1994) Lease (30 years) and concession (33 years)

Johor Port Sale of equity (1995) Lease (30 + 30 years)Bintulu Port Corporatization (1993) LeasePenang Port Corporatization (1994) LeaseLumut Maritime Terminal BOOT (1993) ConcessionPelabuhan Tanjung Pelepas BOOT (1995) ConcessionKuantan Port Sale of equitya Lease

RoadsNorth Klang Straits Bypass BOT (1984) Concession (25 years)Jln. Kuching/Kepong Interchange BOT (1985) Concession (16 years)KL Interchange BOT (1987) Concession (30 years)North-South Expressway BOT (1988) Concession (30 years)Second Link to Singapore BOT (1993) Concession (30 years)Penang Bridge Management contract (1993) Management contract (25 years)Butterworth-Kulim Expressway BOT (1994) Concession (32 years)Seremban—Port Dickson Highway BOT (1994) Concession (30 years)Shah Alam Expressway BOT (1994) Concession (29 years)North-South Expressway Central Link BOT (1994) Concession (25 years)KL-Karak Highway BOT (1994) Concession (27 years)New North Klang Straits Bypass BOT (1995) Concession (25 years)Cheras-Kajang Highway BOT (1995) Concession (30 years)Elevated Highway over Sg. Klang and Sg. Ampang BOT (1996) Concession (33 years)Darnansara-Puchong—Putra Jaya Highway BOT (1996) Concession (33 years)New Pantai Highway BOT (1996) Concession (30 years)Sungai Besi Road BOT (1996) Concession (30 years)

Water supplyLabuan Water Supply BOT (1987) ConcessionIpoh Water Supply BOT (1989) ConcessionLarut Matang Water Supply BOT (1989) ConcessionSemenyih Dam Management contract (1987) Management contractTube well maintenance, Labuan Management contract (1988) Management contractJohor Water Authority Corporatization (1994) LeasePulau Pinang Water Authority Corporatization (1987) Lease

PowerTenaga Nasional Berhad Sale of equity (1992) License (21 years)Independent power producers

YTL—Paka and Pasir Gudang BOT (1995)b Power purchase agreement (21 years)SEV—Lumut BOT (1996–97)b Power purchase agreement (21 years)GSP—Sepang BOT (1994–96)b Power purchase agreement (21 years)PDP—Port Dickson BOT (1995)b Power purchase agreement (21 years)PSP—Powertek, Malacca BOT (1995)b Power purchase agreement (21 years)

TelecommunicationsTelekom Malaysia Berhad (1990) License (21 years)Ten private telecommunications operators License

OthersKTM Berhad (Malayan Railway) Corporatization (1992) LeaseMalaysian Airports Berhad Corporatization (1992) LeaseNational sewerage system BOT (1992) Concession (28 years)Light Rail Transit System I (phase 1) BOOT (1993) Concession (60 + 60 years)Light Rail Transit System I (phase 2) BOOT (1994) Concession (60 + 60 years)Light Rail Transit System II BOOT (1994) Concession (60 + 60 years)

Note: BOT is build-operate-transfer; BOOT is build-operate-own-transfer.a. Transaction was pending in 1996.b. Date of commissioning. Source: Naidu 1995 (updated by author).


Expanding infrastructure is a main chal-lenge for the Chilean economy. Rapid eco-nomic growth, which has averaged 7.4

percent annually over the past decade, is requir-ing massive investment in energy, telecommu-nications, roads, railroads, ports, airports, watersupply, and irrigation. In the next six years theeconomy is expected to grow at about 6.0 per-cent annually and total investment require-ments in infrastructure are estimated at morethan $18 billion (table 4.1).

In order to meet such needs without endan-gering the budget and diverting resources frompressing social needs, Chile has implemented apolicy that allows the private sector to take thelead in infrastructure investment. Private com-panies should meet almost all new investmentrequirements in telecommunications and energyand a major share in the remaining sectors. In thenext six years private investment in infrastruc-ture should account for about $13 billion, or morethan 70 percent of required investment.

Private participation in infrastructureimplies more than capital investment. Chileanpolicymakers also rely on the private sector toplan, build, and operate infrastructure, and tomanage the commercial risks associated withinfrastructure projects. The Chilean economybeneÞts not only from the Þnancial resourcesprovided by private investors but also from theirmanagerial and technical skills.

Major reforms have been introduced in theChilean economy in order to involve the privatesector in infrastructure and reforms are still tak-ing place, since the government is committed tocreating new opportunities for private initia-

tive. Such reforms have changed signiÞcantlythe structure and operations of the infrastruc-ture sector.

From state to markets: a historic overview

Until the 1970s the state was the main player inChilean infrastructure. Through governmentinstitutions and state-owned companies, it wasthe role of the state to plan, Þnance, build, andoperate most of the countryÕs infrastructure.Then in the late 1970s government reformsbegan to reverse the roles. Privatization of thepower and transportation sectors is now nearlycomplete, and private investment is ßowing intoinfrastructure construction.

Major state involvement

Before the Second World War the state was heav-ily involved in building roads, ports, railroads,airlines, irrigation works, and waterworks.After the war state involvement strengthened asa result of policies that explicitly promoted gov-ernment intervention in developing basic infra-structure. State-owned companies were createdfor electricity, oil, telecommunications, ship-ping, and urban transportation. Private compa-nies in such sectors were transferred togovernment ownership. State monopoliesbecame the norm.

By the early 1970s it had become govern-mentÕs responsibility to operate and developnew infrastructure, relying on the national bud-get or income earned by state-owned compa-nies. The government set the prices charged to

55

Alejandro Jadresic

4 Regulating Private Involvement inInfrastructure: The Chilean Experience


customers, at levels that were insufÞcient forself-Þnancing but that reduced inßationarypressures on the economy. Capital shortagesbecame common in the infrastructure sector andnational investment plans could not be com-pleted. Financial deÞcits worsened in state com-panies where social objectives had fostered thehiring of excess personnel.

Customers had no choice but to accept con-ditions imposed by the sole state supplier.Protectionist policies had progressively beenimposed, severely limiting any opportunity fornew investors to enter the market. Barriers toentry also existed in such sectors as fuel distrib-ution, air transportation, and shipping, whereprivately owned companies remained as impor-tant players.

The shift to private provision

In the late 1970s the government introduced rad-ical reforms in the Chilean economy. The guid-ing principles of such reforms were to reduce theintervention of the state in the economy, pro-mote private initiative, open markets to interna-tional trade and foreign investment, stimulatedomestic competition, and lift restrictions limit-ing access of new actors in the infrastructuremarket. State-owned companies were requiredto Þnance their operations and investment plansout of earnings. Prices were deregulated whencompetition was feasible or set at levels thatwould cover costs when state monopolies were

the service providers. State-owned companieswere forced to reduce costs and to Þre excesspersonnel. Stringent budgetary limits wereimposed, constraining not only internal opera-tions but also investment plans.

Once these new economic rules were in placeand state-owned companies had balanced theirbudgets, the decision was made to privatizethose activities that could be run on a commer-cial basis. The government realized that only theprivate sector could provide the funds requiredto resume investment in expansion of domesticinfrastructure. In many cases privatization hadto be preceded by legal reforms in order to trans-fer to the government regulatory and planningactivities previously performed by state compa-nies and to establish competitive regulatoryframeworks. Administrative actions were takento split up large enterprises or transform theminto private corporations.

Starting in the late 1970s and continuingthrough the 1980s, many companies were priva-tized in the infrastructure sectors, including thegas distribution company, the telephone com-pany, Compaatory and planning activities previ-ously performed by state comps companies, Þvepower generation companies, eleven power dis-tribution companies, and an airline (table 4.2).The story of privatization of the electricity andtelecommunication sectors is told in case studieslater in this chapter.

Different sale schemes were used in the pri-vatization process. In the Þrst phase, through1985, entire companies were sold. This made fora faster sale to a single bidder. However, only afew investors could qualify as potential bidders,given the amounts of capital required; at thisstage institutional and foreign investment wasnot yet important. As a consequence, propertywas concentrated in a few hands. It was alsoargued that the prices paid were too low.

To overcome these problems, the next phaseof privatization considered a greater diffusion ofproperty. Very often some shares were keptaside for purchase by employees or for civil ser-vants with the help of long-term credit schemes.The state also granted soft loans to individualsto buy a limited number of shares, which wascalled popular capitalism. During this periodcontrolling shares were auctioned only in the

Table 4.1 Estimated infrastructure investmentrequirements in Chile, 1995-2000

Sector Investment requirements($ millions)

Highways 4,250Urban roads 2,000Water supply 950Sanitation 1,480Community facilities 810Ports 450Railroads 470Irrigation 370Subways 520Airports 100Rain water and river management 195Power industry 3,000Gas industry 1,500Telecommunications 2,500Total investment requirements 18,595

Source: Chile, Ministry of Public Works data.

Regulating Private Involvement in Infrastructure 57

few cases where massive investment wasrequired to boost company development.

Domestic pension funds played a crucial rolein the privatization of state-owned companies,at a time when few large domestic or foreigninvestors were willing to invest in what wasseen as a bold liberal experiment in a develop-ing country with high political risks andunproven regulatory norms. The private pen-sion fund system had been created in the early1980s as a replacement for the almost bankruptsocial security system. The new system intro-duced individual accounts managed by privatecompanies in a competitive environment regu-lated by the state. Workers were required todeposit a set share of their earnings in theseaccounts, with beneÞts based on the accumu-lated value of the accounts at the time of retire-ment. Using these forced savings, the newpension funds acquired large shares in priva-tized companies, particularly in the power andtelecommunications sectors. To this day theyremain a major supplier of funds for the ambi-tious investment programs that these companiesare undertaking in Chile and in neighboringcountries.

During the 1990s privatization of the powersector was completed and that of the trans-

portation sector was begun. Control of all powercompanies has been transferred to the privatesector, with special safeguards to ensure theentry of new players and greater competition.The state shipping company was sold duringthis period and privatization of the railroad sys-tem was initiated in order to stimulate invest-ment and modernization (table 4.3). Investmentduring the 1980s in the state-owned railroad hadbeen very low, leading to infrastructure deterio-ration and a decline in railroad use. After a 1992law allowed the railway company to create apartnership with the private sector, a controllingshare of the rail freight business was privatized,forming two companies: Fepasa, covering thesouthern and central part of the country (1995),and Ferronor, covering the north (1996). In thepassenger business, in both suburban andinterurban services, conditions are being createdto promote private sector participation. A sys-tem is being deÞned that will allow private com-panies to bid for a concession granting them theright to run passenger services on a commercialbasis. In some cases, where the social rate ofreturn is satisfactory but the commercial returnis not, a one-time lump-sum subsidy may beconsidered.

A concessions law has been approved in orderto promote private investment in roads, tunnels,and other transportation infrastructure.Concession arrangements allow major projects tobe developed and Þnanced by private consortiathat recover their investments by charging userfees. This system is described in the road andtransportation case study later in this chapter.

The next round of privatization will affectports, water supply, and sanitation. For thesesectors the government has proposed legalreforms allowing all new investment to come

Table 4.2 Infrastructure companies privatized in Chile,1976–90

Company Yeara Sector

Gasco 1977 Gas distributionFrontel 1980 Power distributionSaesa 1980 Power distributionChilmetro 1986 Power distributionEmec 1986 Power distributionEmel 1986 Power distributionPilmaiquén 1986 Power generationTélex - Chile 1986 TelecommunicationsChilgener 1987 Power generationChilquinta 1987 Power distributionCTC 1987 TelecommunicationsEmelat 1987 Power distributionPullinque 1987 Power generationEdelmag 1988 Power generation and distributionEndesa 1988 Power generationEntel 1988 TelecommunicationElecda 1989 Power distributionEliqsa 1989 Power distributionEmelari 1989 Power distributionLan Chile 1989 Air transportPehuenche 1989 Power generation

a. Refers to the year when private capital gained control of the company.Source: Sáez 1993.

Table 4.3 Infrastructure companies privatized in Chile inthe 1990s

Company Yeara Sector

Edelnor 1994 Power generation and transmissionFepasa 1994 RailroadsEmpremar 1995 ShippingColbún 1996 Power generationFerronor 1996 RailroadsTocopilla 1996 Power generation

a. Refers to the year when private capital gained control of the company.Source: Based on private communication of Rosella Cominetti (EconomicCommission for Latin America).


from the private sector. In the case of ports, state-owned regional companies will privatize opera-tions. In the case of water supply, privatizationof 65 percent of the shares of state-owned com-panies is being considered. Progress to date indelineating public and private roles in the watersupply and sanitation sector is described in acase study later in this chapter.

Guiding principles

Private participation in Chilean infrastructuresectors is guided by four basic principles,embodied in existing laws and in governmentpolicies and initiatives: promote private invest-ment, strengthen competition, protect the envi-ronment, and satisfy basic social needs. Thebalancing of these objectives requires a soundregulatory system.

Promoting private investment

Shortage of infrastructure can become a bottle-neck for development, requiring allocation ofmassive resources to new projects. But funds arerequired to meet pressing investment needs insocial areas such as education, health, and hous-ing, where it is difÞcult to attract private capital.In fact, at present 70 percent of the stateÕs budgetis allocated to social areas. There is no choice butto rely on private capital for infrastructure expan-sion. In addition, private participation works as amechanism to promote efÞciency in constructingand operating infrastructure: the proÞt motivemakes cost reduction a high priority.

Chile has been very successful in promotingprivate investment in infrastructure. A keyincentive has been the persistence of a favorableinvestment climate in the economy as a whole.A stable political system, a well-developedÞnancial sector, openness to trade and foreigninvestment, and capable government institu-tions have contributed to this climate. In addi-tion, regulatory norms established for the mainsectors have applied clear and stable rules. Theduties and rights of private operators aredeÞned in sectoral laws, which clearly distin-guish the regulatory role of the state and themanagerial role of both private and state-ownedcompanies.

The positive business climate and existenceof clear rules have been important not only forprivatizing state-owned companies but tomaintain the ßow of investment. In fact, priva-tized Chilean infrastructure companies havebecome major investors in other sectors inChile and in neighboring countries. After pri-vatization the asset value of ChileÕs infrastruc-ture companies has grown at a rapid pace,much faster than the overall rate of economicgrowth (table 4.4).

Favorable business conditions have alsobeen important to attract investors from Chileand abroad for the concession system that isbeing applied to develop road infrastructure.Low political risks and high credit ratings ininternational Þnancial markets have facilitatedprivate participation in long-term projects (seecase study on roads and transportation).

Strengthening competition

Promoting fair competition is a general policyprinciple for all infrastructure sectors in Chile,since it is the best way of ensuring efÞcient oper-ation and better services to consumers. Chile wasa pioneer in deregulating its power and telecom-munications industries within a competitiveframework. There are no restrictions on investorswishing to enter the market nor on customers,who may choose among different suppliers. As aresult, capacity shortage has been completelyeliminated, the most modern technology is beingused, prices have gone down, and companies arestill earning fair returns (see case studies on elec-tricity and telecommunications).

It is important to stress that no state guaran-tees or privileges are involved in telecommuni-cations or power projects. Companies developprojects at their own risk, estimating demand,setting prices, and negotiating with Þnancialinstitutions. Price regulation applies only tosmall customers for services in markets wherethere are natural monopolies, such as telephoneservices and electricity distribution.

A similar policy has recently been adopted todevelop the natural gas industry, supplied bypipelines from Argentina. An open and compet-itive framework is allowing rapid developmentof this industry, with no involvement by the


national governments in project selection orÞnancing. Equal access is guaranteed to all cus-tomers requiring gas transportation servicesprovided by pipeline owners, and there are noconstraints on investors wanting to build andoperate new gas pipelines.

New legislation is being introduced to createa fair and competitive environment in the portand water supply and sanitation sectors that willallow private companies to provide most of theinvestment required with adequate safeguardsfor consumers. In the case of ports, the largestate-owned company Emporchi will be dividedinto ten separate, autonomous companies,which will be allowed to compete among them-selves and to attract private capital for infra-structure expansion. In the case of water andsanitation, new legislation will allow privatiza-tion of state-owned enterprises, within a regula-tory framework that promotes efÞcientoperation and marginal cost pricing (see casestudy on water supply).

In the case of roads and other transportationinfrastructure, the state has kept a key planningrole but grants concessions to private partiesallowing them to build and operate infrastruc-ture and charge user fees. This newly introducedconcession system ensures a competitive, trans-parent, and open bidding process that allows thebest projects to be chosen. The only state guar-antee is one safeguarding minimum earningsfrom user charges (see case study on roads andtransportation).

Protecting the environment

Environmental protection has become a majorpolitical priority in recent years. New norms andlegislation have been approved to provide clearrules to investors and ensure that all infrastruc-ture projects are developed in a sustainablemanner. Preventing environmental damage isthe reigning principle.

A clearly deÞned review process, with Þxeddeadlines for Þnal authorization, has recentlybeen established, including detailed regula-tions. It requires environmental impact assess-ment studies for most large projects, indicatingany mitigation measures required. Many largeprojects undertaken in recent years have per-formed such studies on a voluntary basis evenwhen not required to do so by law.Environmental studies are reviewed by an adhoc technical committee composed of represen-tatives from public institutions involved. TheNational Commission for the Environment(Conama) or its regional ofÞces, depending onthe projectÕs coverage, makes the Þnal decisionabout the projectÕs environmental feasibility.Third parties that are affected by the projectsmay Þle comments during the review process.

Some infrastructure projects need to meetspeciÞc environmental and safety standards,such as emissions standards for air and liquidpollutants, quality norms for construction mate-rials, and route design constraints for roads andpipes. Such standards are usually based oninternational experience.

Table 4.4 Asset value of selected privatized companies in Chile

Compañía de Teléfonos de Chile Entel Chilgener

Assets Increase Assets Increase Assets IncreaseYear ($ millions) (percent) ($ millions) (percent) (pesos millions) (percent)

1987 507 – 139 – n.a. n.a.1988 754 48.7 154 10.8 n.a. n.a.1989 975 29.3 209 35.7 n.a. n.a.1990 1,379 41.4 259 23.9 n.a. n.a.1991 1,688 22.4 301 16.2 408,515 n.a.1992 2,124 25.8 362 20.3 460,326 12.71993 2,481 16.8 394 8.8 605,245 31.51994 3,065 23.5 533 35.3 643,063 6.21995 3,658 19.3 644 20.8 669,895 4.21996a – – – – 781,484 16.7

– Not available.n.a. Not applicable. a. As of September 30, 1996.Source: CTC, Melo and Serra 1996; Chilgener Estrategia, November 25 and December 16, 1996


Satisfying basic social needs

It is a government objective to provide basicsocial infrastructure to all Chileans. Yet existingpolicy recognizes that it may be unproÞtable forprivate investors to serve isolated areas or low-income groups. To overcome these limitationsthe government provides funds for projects thatmeet minimum social and economic targets.Most infrastructure projects that the govern-ment will Þnance in the next few years wouldvery likely not be developed by the private sec-tor because of low proÞtability or because it isdifÞcult to charge users.

Mechanisms have been introduced to maxi-mize provision of basic social infrastructure byprivate investors. Direct subsidies are the pre-ferred measure. For instance, government fundsare supplied in a competitive way to privateelectric and telecommunications utilities thatserve rural areas and to ships that serve isolatedislands. In the case of water supply and sanita-tion, the state provides a direct subsidy to poorerfamilies, so they can pay the regulated tariffscharged by the companies, which are set at cost.About 20 percent of Chilean families receive thisbeneÞt. Mechanisms like these allow poor fami-lies to satisfy their basic needs without obligingthe state to build or operate infrastructure butonly to provide efÞcient market incentives toprivate investors.

Capable state regulation

Private participation does not imply state with-drawal from the infrastructure sector. On thecontrary, it requires active and effective involve-ment of state entities to ensure that privateactors operate in line with social goals. To dothis, state entities must rely on highly qualiÞedpersonnel who understand and can implementthe regulatory framework. Several state entitiesare involved in Chilean infrastructure.Ministries dictate government policy and areresponsible for the overall performance of spe-ciÞc sectors. The Ministry of Public Works over-sees transportation infrastructure (roads, ports,airports), water supply, sanitation, and irriga-tion. The Ministry of Transport and Telecom-munications is responsible for the operation of

telecommunications and transportation mar-kets, including urban and intercity trafÞc, rail-roads, airlines, and shipping. The NationalEnergy Commission oversees oil, coal, gas, andelectricity markets.

Technical and economic regulation is carriedout by specialized institutions. There are super-intendencias for water supply and for electricityand fuels, subsecretar�as for transport marketsand telecommunications, and direcciones gen-erales for irrigation, roads, and air transporta-tion. In addition, there is a Þscal�a (prosecutorsÕofÞce) and antitrust commissions that monitorcompetition throughout the economy, includingthe infrastructure markets. The NationalEnvironmental Commission is responsible forenvironmental policy and regulation.

The performance of government institutionshelps to explain the positive role that the privatesector has played in Chilean infrastructure.However, further modernization may be neededto ensure that regulatory duties are performedmore efÞciently in the future. For that reason thegovernment is promoting administrative andlegal reforms in order to strengthen technicalcapabilities and enhance the power and auton-omy of regulatory agencies. Recruitment ofhighly qualiÞed staff at the regulatory agenciesis a main concern. Attractive job opportunitiesand good salaries in the private sector make itdifÞcult to attract top professionals needed inthe public sector. A number of incentives arebeing considered, including improved salaryschemes for regulators and use of external con-sultants for highly specialized tasks. Anotherconcern has been to give regulatory agenciesgreater legal authority to ensure enforcement ofregulatory norms. Likewise, arbitration mecha-nisms are being considered for resolution of dis-putes between agencies and companies thatwould minimize the need for court litigation.

Private participation in four infrastructuresectors

Case studies of the electricity, telecommunica-tions, water supply and sanitation, and roadsand transportation sectors describe the processof privatization and the different mechanismsused.


The electricity sector: wholesale divestiture

In its early stages the development of theChilean electricity sector was driven almostexclusively by private initiative, but this sce-nario changed after the Second World War. In1943 the state-owned company Endesa(National Electric Company) was created by theindustrial promotion agency (Corfo) in order tocarry out the national electriÞcation plan.Endesa undertook several tasks. It planned theextension of electricity to cover the whole coun-try, studied the availability of hydroelectricresources, trained the people required for thesectorÕs development, built hydro- and thermo-electric generating units in different regions ofChile, extended trunk lines and started inter-connecting them, and expanded urban and ruraldistribution systems. Endesa was a privilegedstate company and could count on havinghighly qualiÞed personnel and plentifulresources.

Some private companies coexisted withEndesa but they progressively lost ground. Themost important was Chilectra, which producedand distributed electricity in Santiago andValpara�so and their suburbs. In 1970 Chilectrawas nationalized, so by the mid-1970s the statecontrolled 90 percent of generation capacity, 100percent of high-tension transmission lines, and80 percent of distribution systems.

The Þrst step in reforming the electricity sec-tor was taken in 1978 with the creation of theNational Energy Commission (CNE). The com-mission would operate independent of state-owned companies and would promulgatepolicies, development plans, and regulations forthe electricity and other energy sectors. The CNEwould lead the reform process in these sectors.

A new electricity law was approved in 1982,establishing an innovative decentralized modelfor developing the electricity sector, which so farhad operated as a vertically integrated, state-owned monopoly. The new approach involvedthe separation of generation, transmission, anddistribution activities; free entry and competi-tion in electricity generation; a concession sys-tem for distribution; a marginal cost pricingscheme for small customers, which is reviewedevery six months for generation charges and

every four years for distribution charges;mandatory interconnection and rights of wayfor electricity transmission over third-party sys-tems; and a coordination mechanism for loaddispatching.

The next step was to prepare the companiesfor privatization. Chilectra was divided intotwo distribution companies (Chilectra andChilquinta) and one generating company(Chilgener). Regional distribution activitiesand a few smaller generation plants were sepa-rated from Endesa to become individual incor-porated companies. The largest generationfacilities and the transmission lines remainedthe property of Endesa.

Although care was taken to divide existingcompanies, the electricity sector remained quiteconcentrated. Much of the regulatory effort inrecent years has been directed to facilitating theentry and operation of new actors in this market.This might not have been necessary had Chile,like some countries that have undertaken priva-tization recently, been more careful to create acompetitive set of companies before divesting toprivate investors.

In the second half of the 1980s the mainpower companies were privatized, includingEndesa. Open sales of small share packages onthe stock exchange were the basic mechanism.The major buyers were the private pensionfunds, although shares were offered also toemployees and civil servants. Shares in electriccompanies still constitute about half of pensionfund investment in private stocks.

The privatization process generated a posi-tive interaction between the power and Þnancialmarkets. Shares and other Þnancial instrumentsoffered by the electric companies became veryattractive in the Þnancial market. The real valueof electric companiesÕ shares increased almostone thousand times between 1984 and 1994 androse from about 2 percent of the total value ofshares traded in the early 1980s to more than 45percent in the early 1990s (table 4.5).

The electric companies also initiated vigor-ous investment and expansion efforts both inChile and abroad. Over the past ten years elec-tricity consumption has grown about 8 percentannually, while total annual investment isapproaching $800 million. Prices have started to


fall as competition in power generation hasbecome stronger and productivity in distribu-tion companies has increased (table 6). At thesame time the electric companies have becomemajor investors in neighboring countries thathave started to deregulate their own electriccompanies, making use of experience gainedoperating in deregulated markets. Chilean com-panies now control between a fourth and a thirdof installed capacity and distribution in bothArgentina and Peru and are starting to invest inBolivia, Brazil, and Colombia.

The modernization process has received fur-ther impetus during the 1990s. The last remain-ing state-owned power companies have beensold with safeguards ensuring that they wouldnot be acquired by either of ChileÕs main privategeneration companies and that they wouldundertake investment plans to consolidate theircompetitive position in the market. New normsare also being introduced to improve the regula-tory framework, strengthen competition, andensure that new projects protect the environ-ment. These norms cover the quality of serviceto be provided by regulated utilities, the fees tobe paid by power generating companies usingthird-party transmission facilities, and environ-mental impact assessment studies requiredbefore building new projects. Mechanisms havebeen designed to promote investment by privatedistribution companies in rural electriÞcationprojects: state funds are provided in a competi-

tive manner to companies willing to extend theelectricity network in rural areas.

A related development that is having a posi-tive effect on the electricity industry is the con-struction of pipelines across the Andes to bringnatural gas from Argentina for combined cyclethermoelectric plants and industrial and resi-dential uses. The idea of building a gas pipelineis very old but has long met resistance for polit-ical, economic, and technical reasons. In 1990 theChilean and Argentine governments called forinternational bids by private consortia inter-ested in building such a project but had to can-cel when they realized that they had no objectiveway of selecting a winner. The two governmentslater decided to open the market fully and letprivate investors take the initiative. This liberaltrade agreement granted no exclusivity rights orstate guarantees, allowed buyers and sellers toset the terms of the gas supply contracts, andrequired open access conditions for gas trans-portation. These conditions set the stage for suc-cess. Fierce competition developed between twoconsortia until one of them was able to signenough supply contracts with buyers and thisconsortium will start transporting gas in 1997.The second consortiumÕs project was sus-pended, but new private projects to buildpipelines across the Andes and distribute gas inChile are being developed.

Telecommunications: gradual privatization

Telephone service was introduced in Chile asearly as 1880, only four years after its invention.In 1927 the main company was acquired by theInternational Telephone and Telegraph

Table 4.5 Chilean electric company shares traded, 1980–94

Value of Total value of Electricelectricity company shares traded company shares

shares traded (1993 pesos as percentageYear (1993 pesos millions) millions) of total

1980 3,801 201,669 0.021981 1,255 125,816 0.011982 1,148 59,062 0.021983 1,366 29,6227 0.051984 788 23,926 0.031985 5,740 34,107 0.171986 63,242 192,409 0.331987 92,540 309,841 0.301988 93,643 373,108 0.251989 146,617 468,091 0.311990 186,764 394,293 0.471991 403,271 904,104 0.451992 334,595 884,273 0.381993 547,397 1,191,148 0.461994 765,019 2,088,827 0.37

Source: Paredes 1995.

Table 4.6 Chilectra’s electricity losses, 1983–92(as percentage of production)

Year Losses

1983 22.41984 19.31985 20.41986 20.91987 19.81988 18.81989 16.11990 13.61991 13.31992 12.0

Source: Chilectra n.d.


Corporation (ITT), an American corporation,and was incorporated in 1930 as Compa��a deTel�fonos de Chile (CTC). CTC soon acquiredother, smaller companies and became a virtualmonopoly, serving more than 90 percent of themarket.

In 1964 the government created a state-owned company, Entel, to provide national andinternational long-distance services and to rep-resent the country in international agencies suchas Intelsat. In 1971 the government took over themanagement of CTC and in 1974 bought it fromITT. ChileÕs telecommunications sector was thendominated by a state-owned duopoly, with localservices provided by CTC and long-distance ser-vices by Entel. Telephone rates were based onlong-term average costs and a 10 percent proÞtrate was allowed. In practice, however, rateswere kept low for political reasons and rateincreases frequently failed to keep pace withinßation. There were cross-subsidies in favor oflocal service. Investment was modest and unsat-isÞed demand grew.

Reform started in 1977 with the creation ofthe Subsecretar�a de Telecomunicaciones(Subtel), an independent body. Its role was todesign policies and technical norms and per-form regulatory duties, including the grantingof concessions and calculation of tariffs for reg-ulated services.

The principles of the new regulatory frame-work were established in the General Law ofTelecommunications, approved in 1982 andmodiÞed in 1987. The law granted equal rightsto private and state-owned companies, within aconcession system that allows a company (theconcessionaire) to operate providing that it fol-lows a set of well-deÞned regulations. Priceswere freed from regulation except for servicesthat the Antitrust Commission allowed to beprovided under monopoly conditions. Freeentry to the market was allowed for new com-panies. Service and interconnection obligationswere imposed on telephone companies. Cross-subsidies were eliminated and a long-run mar-ginal cost pricing scheme was introduced fortelephone services, with a market proÞt ratedetermined by the capital asset pricing model.Prices were to be recalculated every Þve years,with an index mechanism to be used for the

interim (box 4.1).Privatization of CTC started in 1987, when

minority shares were sold to company employ-ees and to pension funds and a request for bidswas issued for a 30 percent controlling sharewith a requirement for continuing investment.An Australian conglomerate, the BondCorporation, won the bid and then sold its sharein 1990 to a Spanish company, Telefnd to pensionfunds and a request for bids was issued for a 30percent controlling share with a requirement forcontinuing investment. An Australian conglom-erate, tame important minority shareholders.

The privatization of Entel was conductedslightly differently. Between 1986 and 1990 allshares were sold either on the stock exchange orto company employees. The pension funds werethe main buyers. Telef�nica de Espa�a acquired20 percent of the company, but after it took con-trol of CTC the Antitrust Commission forced itto divest its share in Entel. Divestiture was com-pleted in 1993. Today Entel is controlled by apartnership formed by the Chilean companyChilquinta and the Italian company STET/Telecom, each holding 19.5 percent of shares,with the pension funds and other groups asminority investors. As a private company, Entelceased to represent Chile in internationaltelecommunications agencies.

Box 4.1 Calculating regulated local telephone rates

To calculate regulated local telephone rates, service regionsare grouped into a few areas according to demographicparameters. An ideal, state-of-the-art, efficient companyserving each of these areas is defined, usually on the basis ofproposals from the companies, which are checked by theregulator. In this simulation of a competitive environmentprices are calculated on the basis of marginal costs derivedfrom investment and operation costs’ required for serviceexpansion in line with five-year demand forecasts. The pricestructure includes fixed and variable charges, with the vari-able charge depending on the number and duration of calls.The charge per unit of time varies according to the call vol-ume in peak and nonpeak periods of the day. If these chargesdo not yield the allowed profit rate because of economiesof scale, they are adjusted upward, but in such a way as tominimize the resulting reduction in social welfare.

Rates have been set twice according to this procedure,with the second process resulting in a reduction. Telephonecompanies have continued to invest heavily in the expansionof local service coverage.


Further reforms were introduced in the1990s. The law was modiÞed to fully open themarket for long-distance services and introducea multicarrier system allowing any customer tochoose among suppliers for each call. Rates havebeen freed from regulation and new companieshave entered the market, making it one of themost competitive in the world.

In addition, a state fund Þnanced by the bud-get has been created to promote expansion of thetelecommunications network to rural areas.Rural communities prepare and propose pro-jects with government help. The projects areusually attractive from a social perspective butnot from a commercial one. The fund providesan investment subsidy to make the projects prof-itable and private companies compete to receiveit. Proposed projects are evaluated by a centralcouncil according to their social value. This pro-gram is giving hundreds of communities nation-wide access to telephone services.

The deregulation and privatization oftelecommunications have had very positiveresults for the Chilean economy. Investmenthas expanded signiÞcantly. The number of tele-phone lines has more than tripled in eightyears, and unsatisÞed demand has almost dis-appeared (table 4.7). New technologies and ser-vices have been introduced, and the networkhas been fully digitized. Companies havediversiÞed their services in both regulated andnonregulated businesses, including cellulartelephones, cable TV, and private telephoneservices. Seven companies offer long-distanceservices (formerly monopolized by Entel),demand has grown sixfold in the past eightyears, and prices have fallen dramatically.Competition is also developing at the locallevel as new companies have taken on overlap-ping concessions and ambitious expansion pro-jects. Future plans include technologies such asPersonal Communication Systems (PCS),which will compete directly with cellularphones in the short run and possibly with localservice in the long run, as prices fall as a resultof economies of scale and better technology.

Subtel, the state regulator, has played animportant role in deregulating the telecommu-nications sector. It has deÞned policies and mon-itored compliance with existing norms. Today

one of SubtelÕs main objectives is to modernizeitself in order to improve its regulatory perfor-mance. State agencies must match the efÞciencyand productivity improvements of the privatesector. One of the main changes being consid-ered is the creation of a superintendencia oftelecommunications, which would be in chargeof monitoring company compliance with regu-lations and imposing appropriate sanctions,tasks currently performed by Subtel. Subtelwould retain responsibility for the politicalaspects of the telecommunications sector,including the design of laws and regulations, thegranting of concessions, and the calculation ofregulated rates.

Water supply and sanitation: private investment,government regulation

Water supply and sanitation services in Chilehave traditionally been provided by the state.For many years this task was in the hands of theMinistry of Public Works, through itsDirectorate for Sanitary Works, and of severalmunicipal and state companies or agencies serv-ing individual cities. There were also a few smallprivate companies that struggled to survivewith low, government-set tariffs.

Reform was Þrst attempted in 1977 with thecreation of the National Sanitary Works Service(Sendos), which integrated all state institutionsinvolved in water supply and sanitation, includ-ing the Directorate for Sanitary Works and themunicipal companies. Sendos was anautonomous organization within the Ministry ofPublic Works that covered the whole countrythrough eleven regional departments.Sanitation services in the two main cities in thecountry were left in the hands of two state-owned companies: Emos in Santiago and Esvalin Valpara�so. The role of Sendos was to plan,build, and operate water supply and seweragesystems, as well as to set quality standards andmonitor compliance; the Ministry of theEconomy set tariffs. This scheme allowedgreater coordination among state units but hadits problems, stemming mainly from SendosÕsdual role as operator and regulator.

More far-reaching reform was introduced in1989, when the regulatory role of the state was


separated from the operational role of compa-nies, whether state-owned or private. New lawsprovided the framework for efÞcient develop-ment of water supply and sewerage servicesusing a concession system, which imposed sev-eral regulations on concessionaires. They wereallowed to Þnance operations and investmentrequired for expansion with tariffs set every Þveyears according to marginal cost criteria. A sys-tem of direct subsidies for low-income con-sumers was introduced to offset the impact ofhigher tariffs and was essential in allowing tar-iffs to be based on costs. Service obligations andquality norms were imposed on all companies.Compliance with these laws and regulationswas ensured by a system of Þnes and sanctions.

Each of SendosÕs eleven regional depart-ments was transformed into a state-ownedincorporated company with the same rightsand duties as Emos, Esval, and the few remain-ing private or municipal companies.Regulatory duties were assigned to theSuperintendencia de Servicios Sanitarios, anewly created body, which was given the rightto grant concessions to commercial companiesinterested in providing water and sewerageservices, calculate tariffs, impose sanctions,and regulate and monitor compliance withtechnical and quality norms. Its head, thesuperintendente, is appointed by the presidentand has a great deal of autonomy.

The new regulatory model has allowed com-panies to increase investment in sanitation sys-tems based on earnings, expand water supplyand sewerage coverage, and achieve higher

proÞtability (table 4.8). The current administration has decided to

promote further reforms in this sector. In orderto achieve 100 percent coverage for water sup-ply and sewerage, undertake major invest-ment in sewerage treatment plants, andintroduce new technologies and managerialskills, much greater private capital participa-tion is required. Therefore the decision hasbeen made to privatize Emost, Esval, and theregional state-owned companies. A bill wassent to Congress to allow the government tosell up to 65 percent of these companiesÕ sharesto private investors. By retaining a 35 percentshare, the state will keep some veto power overmajor corporate decisions.

At the same time, the government has pro-posed legal reforms that will strengthen the reg-ulatory powers and capabilities of theSuperintendencia. Private control of naturalmonopolies in the water and sanitation sectorwill require stronger regulatory authority.SpeciÞc norms have been considered to improvethe method for calculating tariffs and to restricthorizontal integration of water companies.

Roads and transportation infrastructure: theconcession system

The traditional source of Þnancing for construc-tion and maintenance of roads has been the statefunds allocated to the budget of the Ministry ofPublic Works. Tolls for use of intercity roads andtaxes on transportation fuels have been chargedfor many years, but the resulting income has not

Table 4.7 Chilean telephone service after deregulation, 1987–95

Lines in service Telephone density

Quantity Annual increase Lines per Annual increase Waiting lista

Year (thousands) (percent) 100 inhabitants (percent) (thousands)

1987 581 – 4.65 – 2321988 631 8.6 4.93 6.0 2361989 689 9.2 5.40 9.5 2841990 864 25.4 6.56 21.5 3081991 1,056 22.2 8.02 22.3 2411992 1,279 21.1 9.56 19.2 3141993 1,516 18.5 11.10 16.1 1981994 1,657 9.3 11.97 7.8 1171995 1,894 14.3 13.42 12.1 52

– Not available.a. For Compañía de Telecomunicaciones de Chile (CTC), the largest company.Source: Melo and Serra 1996, based on data from Subtel and company annual reports.

necessarily been used to extend the transportnetwork. Not surprising, supply has fallen shortof demand and the road deÞcit has increased.The investment shortfall became more severe inthe 1970s and the 1980s, since restricting infra-structure investment was a preferred method forÞghting inßation in Chile as in many other LatinAmerican countries. It has been estimated thatduring the 1980s only 30 percent of road invest-ment needs were met. Road trafÞc has increasedalmost fourfold in the past twenty-Þve years,while the road network has remained nearlyunchanged.

In the early 1990s the government realizedthat the road deÞcit could become a major bot-

tleneck to economic development. ChileÕsexport-led growth model needed an efÞcienttransport network, since road transit was grow-ing at 9Ð10 percent annually, and new transportcapacity would be required to handle new tradefollowing trade agreements to be signed withneighboring countries. It was estimated that theannual losses due to the road deÞcit amountedto nearly $1.5 billion, stemming mainly fromcongestion, pollution, accidents, and load lossesdue to inadequate transport infrastructure. Thegovernment also signiÞcantly increased invest-ment in roads, but it became clear that the statewould be unable to meet all investment require-ments. In order to satisfy the medium-term needfor new roads, 1,200 kilometers of roads wouldneed to be paved every year, far more than the500 kilometers paved by the government in agood year.

The solution was to involve the private sectorin obtaining additional funds and also to intro-duce new managerial practices and technologies.The concessions law approved in 1991 estab-lished the framework that would apply for pri-vate companies willing to invest in constructing,operating, and maintaining roads and othertransportation infrastructure. The concessionsystem involves mainly projects deÞned by thestate. Concessions are granted through a biddingprocess, with potential investors submittingoffers that must satisfy speciÞc conditions statedin the terms of reference. The process is trans-parent and competitive and does not involvebilateral negotiations. The concession system isßexible and can be applied to roads, ports, andother transportation infrastructure. The lawallows private pension funds and insurancecompanies to invest in the concession projects.

Bids for road concessions are analyzed fromboth a technical and an economic perspective.Selection is based on such criteria as therequested toll level, the tariff structure, the con-cession period, the subsidy requested or pay-ments committed to the state, the score on thetechnical evaluation, and environmental consid-erations. The selected bidder must create a cor-poration devoted exclusively to the projectdeÞned by the bid.

The concessionaire is required to build orimprove, operate, and maintain the roads dur-


Table 4.8 Performance of the Chilean water andsanitation sector following reform

Investment in sanitation, 1965–95

InvestmentPeriod (1995 $ millions)

1965–70 711971–73 651974–9 681990–95 151

Source: Superintendencia de Servicios Sanitarios data.

Urban residents with water and sewerage services,selected years, 1965–95

Urban Water service Sewerage servicepopulation coverage coverage

Year (millions) (percent) (percent)

1965 5.85 53.5 25.41970 6.67 66.5 31.11975 7.62 77.4 43.51980 8.89 91.4 67.41985 9.66 95.2 75.11990 11.40 97.4 81.81995 11.99 98.6 89.2

Source: Superintendencia de Servicios Sanitarios data.

Profitability of state-owned water and seweragecompanies, 1988–95

Year Profitabilitya

1988 –1.361989 –0.761990 –0.821991 –0.131992 0.941993 3.561994 5.191995 6.30

a. Profits after taxes as percentage of total assets.Source: Superintendencia de Servicios Sanitarios data.

ing a concession period lasting no more thanÞfty years in exchange for toll income. The gov-ernment usually offers a minimum income guar-antee based on trafÞc assumptions. Thisguarantee, which is normally accepted by thewinning companies, has two main goals: to helpthe private investor obtain Þnancing and toshow the stateÕs commitment to the project. TheÞnancial backing is important, since the conces-sion grants only the right to exploit the infra-structure for a given period; the state remainsthe owner of the road works from the beginningof the project. The income guaranteed by thestate usually covers maintenance costs andabout 70 percent of operating and capital costs.But if proÞtability exceeds a previously estab-lished level (usually 15 percent), the concession-aire has to share the additional income equallywith the state. A conciliation mechanism isavailable in case of conßicts arising between theinvestor and the state during the concessionperiod.

Private investors may also propose new pro-jects. If a project is accepted, the company thatproposed it receives a bonus in its bid and mayreceive a full or partial refund of the develop-ment costs associated with the project. Manyprojects have been proposed, several have beenaccepted (including two airport terminals andurban and interurban roads), and some arebeing built.

The Ministry of Public Works has created aConcessions Division to regulate the concessionsystem. This division deÞnes projects to beoffered, manages the bidding process, andsupervises project construction and operation .Regulations governing the concession systemand the bidding process have evolved over time.The government has introduced modiÞcationsto solve problems as they have arisen, taking

into account international experience.The Þrst concessions were awarded in 1993.

Two projects have been Þnished so farÑone tun-nel and one roadÑseveral more are being built,and others will soon be tendered. The estimatedvalue of projects to be awarded in 1993Ð99exceeds $4 billion (table 4.9).

Although it is too soon to evaluate the long-term operational outcome, the Chilean experi-ence with the concession system has so far beenvery positive. The private sector, both in Chileand abroad, is highly motivated to invest inroads and other transportation infrastructurethat the economy badly needs in order to keepgrowing. The system allows reduction of theroad deÞcit while freeing government resourcesfor other uses, including the construction ofroads that are socially desirable but do not meetminimum commercial conditions to be offeredas concessions.

Several factors help to explain the positiveresponse from private investors to concessionprojects, even if the expected proÞtability is nothigh. Internationally, the country is assessed asone with low political risk and institutional andmacroeconomic stability. The Ministry of PublicWorks has carefully overseen thorough prepara-tion of the required studies and undertakenbroad promotional efforts. Investors also cannothave failed to notice the steadily increasingdemand for this type of infrastructure, whichcan be expected to keep pace with the economyÕssustained growth.

Conclusion

Chile has come a long way in deregulating andprivatizing its infrastructure sectors. The privatesector is now involved not only in Þnancinginvestment projects but also in planning, build-


Table 4.9 Road and transportation projects offered for concession in Chile, 1993–99

Amount to be awarded ($ millions)Investment

Projects ($ millions) 1993 1994 1995 1996 1997 1998 1999

Route 5a 1,690 0 0 160 710 820 0 0Urban concessions 870 0 0 10 250 290 100 220Interurban concessions 1,533 42 30 381 140 440 500 0Total 4,093 42 30 551 1,100 1,550 600 220

a. Route 5 is the country’s main highway. It is part of the Panamerican Highway System stretching from Alaska to Patagonia.Source: Chile, Ministry of Public Works 1996.

ing, and operating new infrastructure facilities.Such participation is guided by general princi-ples, including promoting investment, ensuringfair competition, protecting the environment,and satisfying basic social needs, and by capableregulation.

The current situation owes its success to thedesign of major reforms that have been intro-duced over the past twenty years. Generallyspeaking, sectoral reforms have started with thecreation of a regulatory institution to lead theprocess and of a legal and regulatory frame-work. The next step has been the privatization ofstate-owned companies in the case of electricityand telecommunications and the granting ofconcessions to let the private sector undertakenew projects in the case of roads. This sequenc-ing strategy has proved to be effective. Privateinvestment requires clear and stable rules estab-lished by law and a regulatory body indepen-dent from potential state-owned competitors.Accelerating the process by starting privatiza-tion without a proper regulatory frameworkdoes not seem to pay off, since high risk willdrive away potential investors and it is difÞcultto modify regulations once property rights havebeen awarded.

Private participation in infrastructure hashad strongly positive effects on the Chileaneconomy. Massive private investment has beentaking place in energy and telecommunicationsnetworks and is starting to ßow into the road,water supply, and other infrastructure sectors.Such investment is allowing the economy tomaintain high growth rates and the governmentto use its resources for social objectives. Usershave beneÞted from more and better services atreasonable prices. Companies have increasedtheir productivity, earned fair returns, anddiversiÞed their operations in Chile and abroad.

Private participation in infrastructure hasposed new challenges for the Chilean govern-ment. It has been moving away from managerialactivities and has had to develop new regulatoryskills. Just as private companies are modernizingand becoming more competitive, the state isreshaping itself to incorporate the humanresources and technology required to ensure efÞ-cient private development in infrastructure.Consequently, it is promoting administrative

and legal reforms that will strengthen its Þnan-cial and technical capabilities as well as thepower and autonomy of its regulatory agencies.

Notes

The author is Minister President of the NationalEnergy Commission. The author wishes to acknowl-edge Mr. Gaston Held for his valuable help, especiallywith the case studies, for the field work performed,and for his useful comments.

References

Acevedo, Roberto, and Juan Err�zuriz. 1994.ÒInfraestructura: oportunidad u obst�culo para eldesarrollo.Ó (Infrastructure: opportunity or obstaclefor development.) In Felipe Larra�n, ed., Chile haciael 2000: Ideas para el desarrollo. (Chile in the year2000: Ideas for development.) Santiago de Chile:Centro de Estudios P�blicos.

Al�, Jorge, and others. 1990. ÒEstado empresario y pri-vatizaci�n en Chile.Ó (Entrepreneurial state and pri-vatization in Chile.) Cuadernos Universitarios, SerieInvestigationes 2. Universidad Nacional Andr�sBello, Facultad de Ciencias Econ�micas yAdministrativas, Santiago de Chile.

Chile, Ministry of Public Works. 1996. ÒPrograma gen-eral de concesiones.Ó (General concession program.)Coordinaci�n General de Concesiones, Santiago deChile.

Chilectra. No date: ÒChilectra highlights.Ó ChilectraMetropolitana (Company publication).

D�az, G.-H., Gonzalo Adolfo, and Mario A. L�pez M.1996. ÒRepresentaci�n y proyecci�n tarifaria deempresas y otras consideraciones en torno a la legis-laci�n de servios sanitarios.Ó (CompaniesÕ tariff pre-sentations and projections and other issues in waterand sanitation services legislation.) Universidad deChile, Departmento de Ingener�a, Santiago de Chile.

Fischer, Ronald D. 1995. ÒEconom�a de las concesionesviales en Chile.Ó (Economics of road concessions inChile.) Universidad de Chile, Departamento deIngenier�a Industrial, Centro de Econom�a Aplicada,Santiago de Chile.

Galal, Ahmed, and others. 1994. Welfare Consequences ofSelling Public Enterprises: An Empirical Analysis. NewYork: Oxford University Press.

Jadresic, Alejandro. 1993a. ÒDesregulaci�n econ�mica:avances y tareas pendientes.Ó (Economic deregula-tion: progress and impending tasks.) In EugenioLahera, ed., C�mo mejorar la gesti�n p�blica. (How toimprove public management.) Santiago de Chile:Cieplan/Flasco Foro 90.

ÑÑÑ. 1993b. ÒLa transformaci�n de la producci�n, elcrecimiento y la competitividad internacional en la


experiencia chilena.) Production transformation,growth and international competitiveness in theChilean experience.) In Studies and Reports of theEconomic Commission for for Latin America 84.Santiago de Chile.

Melo, Jos� Ricardo, and Pablo Serra. 1996.ÒCompetencia y regulaci�n en telecomunicaciones:La experiencia chilena.Ó (Competition and regula-tion in telecommunications: the Chilean experi-ence.) Universidad de Chile, Departamento deCiencias F�sicas y Matem�ticas, Santiago de Chile.

Paredes, Ricardo. 1995. ÒEl sector el�ctrico y el merca-do de capitales en Chile.Ó (The electric sector andcapital markets in Chile.) Paper LC/R 1496.Santiago de Chile: Economic Commission for LatinAmerica.

Rojas Pinaud, Alejandro. 1994. ÒExperiencias de priva-tizaciones en Chile: Lan Chile, Entel y CTC.Ó(Privatization experience in Chile: Lan Chile, Enteland CTC.) Working paper 2. Universidad AdolfoIb��ez, Instituto de Econom�a Pol�tica.

S�ez, Ra�l E. 1993. ÒLas privatizaciones de empresasen Chile.Ó (Privatization of companies in Chile.) InOscar Mu�oz, ed., Despu�s de las las privatizaciones:Hacia un estado regulador. (After privatization:toward a regulatory state.) Santiago de Chile:Cieplan.

Superintendencia de Servicios Sanitarios. 1996.ÒMemoria anual 1995.Ó (1995 annual report.)Santiago de Chile.


Governments struggle to attract privateinvestors to infrastructure projects andto address the problems created by unre-

solved environmental or resettlement issues.Private investors are acutely aware of the Þnan-cial risks to infrastructure projects posed by envi-ronmental and resettlement concerns. Examplesof how these problems can affect private invest-ment in Asian infrastructure abound in thepower, water, and transporatation sectors.1

The risks associated with environmental andresettlement issues reduce the attractiveness ofinfrastructure projects. But these problems canalso create opportunitiesÑfor governments toimprove local environmental and social condi-tions cost effectively and for private investors tomake money. Privately Þnanced water supplyand treatment plants can improve water safety,and longer-term prospects of populationsaffected by resettlement can be improved, forexample.

East Asian governments must consider twofundamental sets of questions as they strive toreduce deterrents to private investment. First,why are private investors concerned about envi-ronmental and resettlement risks? What legal,operational, and political risks do environmen-tal and resettlement issues pose to infrastructureprojects? How do the impacts of those risks varyacross different types of infrastructure projectsdepending on their location, design, construc-tion, operation, secondary impacts, and politicalsensitivity? Second, what steps can govern-ments take to make private investors more com-fortable with the level of environmental orresettlement risk facing a project and to help

71

Bradford S. Gentry

5 Managing Environmental andResettlement Risks and Opportunitiesin Infrastructure

them capture the opportunities to address keyissues through private involvement? Beforeaddressing this question governments must rec-ognize that their role has changed, but not beeneliminated or diminished in importance, andthat affected communities need to be incorpo-rated into the risk mitigation process.

Governments should then follow Þve basicsteps for managing environmental and resettle-ment risks and opportunities:

¥ Identify risks and opportunities throughenvironmental assessments (including reset-tlement issues) and investor due diligence.

¥ Assess the relative Þnancial importance ofparticular risks and opportunities.

¥ Take advantage of opportunities and miti-gate substantial risks through design of theproject, the environmental legal framework,and the resettlement plan.

¥ Allocate the residual risks to the parties bestable to manage them (sponsors, govern-ments, development banks, privateÞnanciers).

¥ Implement risk mitigation steps in a timelyand effective manner.Environmental and resettlement risks can be

managed and opportunities captured. Theymust, however, be treated not as a special cate-gory of problems but as key objectives.

Environmental and resettlement risks asdeterrents to private investment

The goal of any private investor is to Þnd dealsthat offer predictable and acceptable returns. Inthe infrastructure sector this search is compli-

cated by the long timeframes over which returnsare earned and the ÒpublicÓ nature (and hencepolitical sensitivity) of the services provided.The level of risk inherent in such long-term, sen-sitive investments leads Þnanciers to address asmany signiÞcant risks at the outset as they can.

Environmental and resettlement issues cancreate enormous uncertainty for investors. Theycan increase completion risk through delays,failure to obtain necessary authorizations, andcancellation in the face of public opposition.They can increase project risk by increasing con-struction or operating costs, reducing future rev-enue streams, or decreasing the value ofcollateral. In extreme cases they can pose directrisks to Þnanciers through liability or the com-mercial impact of international protests.

Public opposition to infrastructure projectsbecause of environmental and resettlement con-cerns is now Þnding its way into the courts inEast Asia, further increasing uncertainty forinvestors. In June 1996 the Kuala Lumpur HighCourt ruled that the governmentÕs approval ofthe environmental impact assessment (EIA) forthe Bakun hydroelectric project in Sarawak wasillegal (box 5.1). Delays to the project would costalmost $4 million a day, according to the chair-man of the project company.

Types of environmental and resettlementrisks

The environmental and resettlement risks facingany project fall into three main categories: legal,operational, and political.

Legal risks

Legal risks arise when a project is not in compli-ance with all applicable procedures and stan-dards, including both local laws and thecontractual requirements of investors. If the pro-ject does not meet local requirements, it may besubject to delays, enforcement, lawsuits, closure,or cancellation. If the project does not meet bothlocal and investor requirements, its chances ofattracting international Þnancial support aresubstantially diminished.

National environmental requirements areoften extensive, with regulations setting envi-ronmental assessment procedures, project sitingapproval processes, environmental standards forproject operation, and liability for environmentaldamage. National resettlement requirements inEast Asia tend to be less developed than else-where, and many countries in the region lackadequate laws on compensation for taking of pri-vate lands or fail to enforce them. Only one coun-


The $5.5 billion Bakun hydroelectric power project has longbeen opposed by environmental and other NGOs. The damis designed to provide 2,400 megawatts of power to peninsu-lar Malaysia through a 650-kilometer long undersea cable fromthe state of Sarawak on the island of Borneo. Located deep inthe jungle, the dam would reportedly flood an area the size ofSingapore and force more than 9,000 local tribespeople torelocate.

Although the Sarawak government offered to provide newhomes or more than $120 million in compensation to thosebeing moved, three of the people to be relocated filed suit,challenging the government’s approval of the EIA for the pro-ject.

In its ruling the High Court found that the national gov-ernment had violated the National Environmental Quality Actby transferring responsibility for approving the EIA to the stateauthorities in Sarawak (a shareholder in the project).Differences in federal and state procedure meant that the trans-

fer had the effect of eliminating plaintiffs’ right to participate inthe EIA process. The court ruled that Ekran, the developer ofthe project, had to comply with the national act before it couldbuild the dam. The decision has been appealed to a highercourt.

The project is proceeding (the plaintiffs’ request that aninjunction stopping work be issued was denied by the AppealsCourt). But the search for financing (a large part of which isreportedly to be secured by floating shares in the dam’s oper-ating company) has been made more difficult by the suit, andfinancial analysts believe that the legal issues must be resolvedbefore financing can take place. In addition, ABB, the con-struction contractor for the dam, has been the subject of a peti-tion drive by more than 100 NGOs and 30 members of theEuropean Parliament seeking its withdrawal from the project.Friends of the Earth has also said it will step up its lobbying ofinvestors in ABB and Ekran.

Box 5.1 Public opposition to the Bakun hydroelectric project in Malaysia complicates financing

Managing Environmental and Resettlement Risks and Opportunities in Infrastructure 73

try in the region (China) has a legal frameworkfor addressing the broader social issues createdby involuntary resettlement.

The search for support from multilateraldevelopment banks brings with it the need tomeet additional environmental and resettlementrequirements, such as those implemented by theWorld Bank (Operational Directives 4.01 onenvironmental assessment, 4.20 on indigenouspeoples, and 4.30 on involuntary resettlement).These requirements have been adopted, in largepart, to address the criticisms leveled by envi-ronmental NGOs and others over the develop-ment banksÕ historical lack of sensitivity toenvironmental and resettlement issues.

In some cases these standards parallel localrequirements; in many cases they go beyondnational laws. Included are guidelines for envi-ronmental and resettlement review procedures,minimum environmental performance stan-dards (such as the 1995 World BankÒGuidelines,Ó described in box 5.2), areas to beaddressed in resettlement action plans (box 5.3),and public notice and consultation.

Although some countries have raised sover-eignty objections to the existence of internationalstandards, their use is on the rise. The U.S.Export-Import Bank (ExIm Bank) and theOverseas Private Investment Corporation (OPIC)have adopted environmental procedures andstandards similar to those of the World Bank. In1995 OPIC took steps to cancel the political riskinsurance it had issued to Freeport-McMoRanbecause of the scope of the environmentalimpacts from the companyÕs Irian Jaya copperand gold mine. Other national export credit agen-cies are under increasing pressure to follow thelead of the ExIm Bank and apply similar stan-dards to their export assistance programs.

Even more important is the growing numberof commercial bankers and underwriters wholook beyond local law to international standardson environmental and resettlement issues. Thestarting point for a commercial bankerÕs analy-sis is determining whether a project is in com-pliance with local law, whether or not the law isever enforced in practice. In countries in whichenforcement is lacking, pressure from the Þnan-cial community to improve compliance repre-sents a new and powerful inducement to meetlocal requirements at the outset of a project.Many bankers, particularly those from indus-trial countries, then consider compliance withinternational standards, which is necessarywhen development bank support is sought.Even where such support in not sought, how-ever, compliance with international standards isincreasingly viewed as a useful defense in theface of international protests over a privateinvestorÕs involvement in a particular project(see box 5.15).

Operational risks

Operational risks reßect the technical and man-agerial capacity of the project team to meet thenecessary standards. The level of risk dependson the ability of the facility to meet applicablestandards at the commencement of operations

Box 5.2 The World Bank’s pollution prevention andabatement handbook

In 1995 the World Bank released a draft handbook [TITLE?]on the environmental performance of the industrial projectsit supports. Commonly referenced by public and privateinternational financiers, the handbook includes suggestedemission limits for different types of projects. The limits forthermal power stations, for example, cover air emissions,liquid effluent, and solid waste. Recommended monitoring

Box 5.3 World Bank criteria for resettlement plans

The World Bank’s directive on involuntary resettlement(OD 4.30) applies to Bank support of infrastructure projectsthat use public eminent domain powers to acquire land,whether private investors are involved or not. It includes thefollowing list of factors to be addressed by governments:

• Organizational responsibilities• Valuation of and compensation for lost assets• Identification of vulnerable groups• Resettlement finance and budgeting• Community participation• Land tenure, acquisition, and transfer• Integration with host populations• Training, employment, and credit• Socioeconomic survey• Shelter, infrastructure, and services• Legal framework• Environmental protection and management• Alternative sites and selection• Implementation schedule and monitoring.


(Has it been properly designed? Does the equip-ment work as planned? Was the resettlementplan properly implemented?) and the ability ofthe operator to provide reliable performanceover time (Are trained personnel and manage-ment systems in place? Are the required actionsbeing taken?). Because operating companiestend to be experienced, the level of risk can beassessed by technical consultants, and contrac-tual protections and insurance can be secured,operating risks are usually less worrisome toinvestors than legal or political risks.

Political risks

Political risks, which include the risk of opposi-tion to the project and the risk of major changesto the laws governing project construction oroperation, are usually the most worrisome toprivate investors in long-term infrastructureprojects. Public opposition is the most unpre-dictable risk. Most of the other environmentaland resettlement issues can be efÞcientlyaddressed by project sponsors and the govern-ment if they are well managed and sufÞcientresources are marshaled.

Environmental and resettlement issues areamong the most likely to generate signiÞcantlocal or international opposition and press cov-erage. The intensity of the opposition dependsnot only on the characteristics of the project but

also on the way it is handled. Problems can beexacerbated if the government and the sponsorsdo not demonstrate a willingness to understandand address local and international concerns, atleast to some degree. This is particularly true forresettlement issues.

Public opposition can increase both comple-tion and project risks by (a) delaying a project,(b) raising project costs as a result of requireddesign changes, (c) increasing the possibilitythat the government will cancel the project, (d)reducing the number of potential investors, (e)impairing the operatorÕs ability to maintain orcollect adequate user fees, and (f) in extremecases, placing project facilities and personnel atphysical risk. Examples of some of these effectscan be found in transport projects in Bangkok,Thailand, and Guangzhou, China (boxes 5.4and 5.5).

Changes in the law, particularly in rulesaffecting a projectÕs financial performance, arealso a major concern to investors. Sometimesreferred to as Òcreeping nationalization,Ó thisrisk involves unanticipated changes by thegovernment to the rules governing the projectthat reduce the expected return to investors. Ofgreatest concern are reductions in the level offees charged to users. Protests over express-way tolls in Indonesian and Malaysian andsewerage fees in Malaysia have complicatedprivate sector involvement and loweredreturns to investors (box 5.6). Unexpectedtightening of the environmental standards orwidening of the scope of resettlement effortsmay have similar effects by raising projectcosts.

Box 5.4 Environmental protests delay constructionof light rail in Bangkok

Environmental protests have added to the delays and costsfacing the already complicated efforts to build three masstransit lines to help ease Bangkok’s chronic traffic problems.Two of the lines have been sponsored by Thai developers(Tanayong and Bangkok Land) and one has been sponsoredby a Hong Kong firm (Hopewell Holdings).

In response to public pressure to move undergroundto reduce noise and visual impacts, the Thai governmenthas imposed numerous conditions on the projects, includ-ing the commissioning of additional environmental studiesand the increased use of underground routes. The farthestalong project, Tanayong, has had to move its main depotto a new location as a result of environmental protests.Difficulties in resolving environmental issues and frequentchanges in Thai government policy on transport projectshave substantially increased the difficulties facing privateinvestors in these projects.

Box 5.5 Resettlement issues delay transport projectsin Guangzhou, China

Guangzhou, southern China’s most prosperous city, hasattracted considerable private interest in transportation pro-jects, although resettlement issues have been a continuingsource of controversy. Resettlement compensation wasraised as part of the city’s efforts to reach agreement withHopewell Holdings for the East-South-West Ring Road, a tollroad project that has been stalled by disagreements overinvestment costs. Significant delays have been experiencedover the resettlement of more than 140,000 residentsaffected by Metro subway line number one.


Effects of environmental and resettlementrisks on different types of infrastructureprojects

The environmental and resettlement risks facingan investment depend on the following factors,which vary from sector to sector, project to pro-ject, and location to location: (a) the sites chosenfor both main and ancillary facilities; (b) thedesign, including expected emissions and otherimpacts; (c) construction; (d) operation of thecompleted facilities; (e) secondary impacts,including opening up new areas to develop-ment; and (f) political sensitivity over the type ofservice provided or project undertaken. Thenature and intensity of environmental and reset-tlement issues varies across types of infrastruc-tur projects (table 5.1).

Site selection raises a host of difÞcult issues,particularly for hydropower, highway, rail (box5.7), and ancillary thermal power facilities, includ-ing fuel source, fuel transportation, and powertransmission. The need to resettle residents is amajor factor in most of these cases. Flooding ofwilderness areas for hydropower facilitiesdestroys forests and biodiversity. Cultural, reli-gious, or archeological sites and wildlife areasmay also be affected. All of these issues raise sig-niÞcant legal, operational, and political risks.

Plant design determines the environmentalimpacts of facility operations as well as the num-

ber of people to be relocated. Air pollution con-trol issues are most pressing for coal-Þred powerstations, given the concerns over the impact ofdust on local health; acid gasses on local health,

Since it was awarded the national sewerage concession in1993, Indah Water Konsortium (IWK) has faced a storm ofprotest over the fees it charges. The result has been govern-ment-ordered reductions and substantial disruptions in gettingthe business up and running, both of which have fueled con-tinuing protests over the lack of improvement in services.

Before the concession was awarded, sewerage serviceswere the responsibility of 144 separate local authorities, andfees were included in the general local rates. Operational per-formance was poor and underinvestment in infrastructure wasa serious problem. As the government struggled to find ananswer to the growing concern over sewage pollution, IWKproposed a national concession. The concession was approvedby the legislature, and a new regulatory framework was estab-lished for IWK’s fees.

Protests over the new sewerage charges began almostimmediately. Commercial users of water found themselvesconfronted with substantial bills for sewerage services, regard-less of the quantity or quality of their effluent. No correspond-ing reductions in local rates were made, and no immediateimprovements in service were apparent to the public.

In response to the protests, the government reducedcommercial fees over the first three years of the concession, ineffect phasing in the new charges. Although this reduction qui-eted some of the public opposition, fee and service issues havecontinued to dog IWK. In late May 1996 the company placedfull-page ads in all major newspapers announcing a completereview of its operations, including the possibility of furtherreductions in fees.

Box 5.6 Protests over sewerage fees force rollback in Malaysia

Box 5.7 Government fails to meet internationalstandards in dealing with relocation issues in Manila

One of the major unresolved issues facing the EDSA LightRail Transit Project in Manila (LRT 3) is the need to move atleast 17,000 squatters from the site on which a depot is tobe built. A portion of the site has been cleared of commer-cial premises through a series of lawsuits and evictionnotices. Efforts to relocate the squatters residing on the sitebegan in the fall of 1995 and had not been resolved by 1996.Part of the delay stems from the difficulty of finding accept-able sites for resettlement. The site preferred by the gov-ernment is twenty-five kilometers from the depot site andrelatively inexpensive. The other possible site is six kilome-ters from the depot site, abuts a garbage dump, is morecostly, and would require more time to prepare. Residentshave reportedly rejected the first site.

The government’s approach to the resettlement prob-lem did not meet evolving international norms. In particular,the government failed to (a) undertake a comprehensivesocioeconomic survey, including a survey of residents’ atti-tudes on a wider range of resettlement options; (b) system-atically solicit public input on the resettlement plan; (c)consider acceptable resettlement alternatives, includingthose providing comparable access to employment, infra-structure, and services; and (d) offer measures to help pro-tect the welfare of the affected families during and for aperiod after resettlement.


Table 5.1 Relative importance of environmental risks to various types of infrastructure projects

Thermal power Hydro power Renewable power Drinking water Sewerage Highway Rail

Site selectionMain facility ✓ ✓✓✓ ✓ ✓ ✓✓ ✓✓✓ ✓✓✓Ancillary facilities ✓✓✓ ✓✓ ✓✓ ✓ ✓✓ ✓ ✓

Plant designAir ✓✓✓ ✓✓Water ✓ ✓✓✓ ✓✓✓ ✓✓✓ ✓ ✓Waste ✓✓ ✓✓✓Noise ✓ ✓ ✓ ✓✓✓ ✓✓✓Health and safety ✓✓ ✓ ✓ ✓ ✓ ✓✓✓ ✓✓✓

ConstructionAir ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓Water ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓Waste ✓ ✓ ✓ ✓ ✓ ✓ ✓Noise ✓ ✓ ✓ ✓ ✓ ✓✓ ✓✓

OperationsManagement ✓✓✓ ✓✓✓ ✓ ✓✓✓ ✓✓✓ ✓ ✓Health and safety ✓✓ ✓✓ ✓ ✓ ✓ ✓ ✓✓Emergencies ✓ ✓✓ ✓✓✓ ✓✓ ✓✓ ✓✓

Secondary impacts ✓ ✓✓✓ ✓ ✓✓✓ ✓

Political sensitivity ✓✓ ✓✓✓ ✓ ✓✓✓ ✓✓✓ ✓✓ ✓✓

Note: Intensity of risk is indicated by number of checks.

A unique set of relationships is emerging between China andJapan as they struggle through the environmental and eco-nomic implications of the rapid expansion of coal-fired powerstations in China.

The internal debate over increased coal use is intensifyingin China. In March 1996 the federal cabinet released a reportto the National People’s Congress stating that the coal sectormust “accelerate production to meet the country’s increasingenergy demands.” In April 1996 the Chinese Ministry of PublicHealth and the State Science and Technology Commissionreported that pollution was now a leading cause of illness anddeath in many Chinese cities and that air pollution, much of itcaused by the burning of coal, was of particular concern. Similarresults from earlier studies led a Standing Committee of theNational People’s Congress to call for much tighter controls onsulfur dioxide emissions in the fall of 1995. The governmentwas thus faced with the need to both increase coal productionand reduce air pollution, something it could achieve only byinvesting in air pollution controls.

Japan has many reasons to try to help China reduce the

environmental impacts of its expanding power sector. Concernthat acid rain from China is damaging Japanese forests is grow-ing. Japan is a leading exporter of air pollution control equip-ment, and the Chinese market is potentially huge. Japanesecompanies are also seeking to participate in the growth of pri-vate sector involvement in Chinese infrastructure and otherprojects.

The result has been a number of “cleaner coal” initiativesin China sponsored by the Japanese government. As part of its“green aid” program, the Japanese Ministry of InternationalTrade and Industry has been demonstrating the use of lower-priced flue gas desulferization equipment in a small number ofChinese power plants. In 1996 the Japanese OverseasEconomic Cooperation Fund announced that it was focusing itsnew special loan program to China on environmental projects,including cleaner coal usage, and formal agreement amongChina, Japan, and Germany was expected on the cosponsor-ing of a feasibility study for a coal liquefaction plant (expected tocost $500–$600 million).

Box 5.8 Japan and China work together to develop cleaner coal


buildings, and ecosystems; and carbon dioxideon global warming (box 5.8). Water qualityissues are critical to the operations of water andhydroelectric facilities. The need to dispose ofsewage sludge creates major waste issues forsewerage systems. Noise is a major factor intransportation projects and presents at leastsome risk to most other projects as well.

Construction generates signiÞcant environ-mental impacts, which are usually temporaryand manageable by qualiÞed contractors. Theserisks are thus largely operational risks. Duringoperations the quality of managementÕs imple-mentation of the environmental and resettlementprograms is key to the success of the project.Failure to implement a well-designed operationsor resettlement plan increases the risks to privateinvestors. EmergenciesÑsuch as release of toxicmaterialsÑare a particular concern in drinkingwater systems, where operational risks are usu-ally the principal concern. Secondary impactsrange from the ancillary development spurredby the opening of highways into new areas to theincreases in consumption of resources that oftenaccompany expanded access to power or roads.These impacts generally increase legal risks inthe structuring of the project or political risksover its life.

The political sensitivity of different types ofprojects is critical and affects all aspects of pro-ject preparation and implementation. For pro-jects that have come under the publicspotlightÑlocally or internationallyÑnew hur-dles to project completion are erected (table 5.2).

Addressing the risks and taking advantageof the opportunities posed byenvironmental and resettlement issues

All of these environmental and resettlementissues can be managed once government accepts

that increased private involvement in infra-structure means that its role has only changed,rather than been eliminated or even diminishedin importance, and that public involvement iscritical. While governments no longer have pri-mary funding or operating responsibility, theyset targets and frameworks for private involve-ment at the outset and have an ongoing respon-sibility to monitor performance and applyframeworks in a predictable and consistentmanner over the life of the project. This changedrole affects both project design and regulatoryoversight activities. Effectively meeting thesenew responsibilities means that the governmentand the private operator have to build a long-term working relationship based on clearlydeÞned roles. While each has its own areas ofexclusive responsibilityÑwith the governmentresponsible for regulation and the operatorresponsible for technical performanceÑjointaction will be necessary on many issues, includ-ing major resettlement issues. Since it is impos-sible to anticipate and provide for all

Box 5.9 Public opposition to coal-fired power plantssuspends construction in Thailand

During the 1990s a number of coal-fired power plantsbecame the subject of environmental protests in Thailand.One of the earliest was the Mae Moh station, in northernThailand. In October 1992 adverse weather conditions anda malfunction at the plant created an air pollution event thatcaused hundreds of residents to require treatment for res-piratory problems. As a result the Electricity GenerationAuthority of Thailand had to cut back production at the plant,reducing its already strained total generating capacity by 3percent.

In early 1996 construction of an experimental powerstation was suspended by the government following protestsby local residents. Designed primarily to burn municipal solidwaste, the plant had also planned to use coal for up to 40percent of its fuel in its early years.

Issue

Resettlement of large numbers of people, particularly indigenous peoplesor squatters (box 5.1)

Imposition of new or significantly increased user fees on “public” services(box 5.6)

Destruction of large areas of tropical forest or other sensitive habitats(box 5.14)

Emission of large quantities of air pollutants affecting local, regional, andglobal environmental conditions (box 5.9)

Types of projects particularly affected

Hydropower facilities, highway, and rail lines

Water supply or wastewater treatment, roads, electricity

Hydropower facilities

Coal-fired power stations

Table 5.2 Politically sensitive issues that can affect infrastructure projects


changes should be made to project designrequires judgment.

Although project sponsors may fear thatinforming the public may delay or even derail aproject, experience has shown that done wellpublic outreach is the best way to minimize therisk of signiÞcant public opposition and savestime and money over the life of the project. InCalcutta, India, for example, an outreach pro-gram involving private investors successfullydeveloped a resettlement plan (box 5.11). Somemultinational companies view public involve-ment as the means of obtaining the Òsociallicense to operate,Ó which they regard as just asnecessary as any legally required permits.

Addressing environmental and resettlementissues is a continuing process that involves bothprivate and public parties. A Þve-step processconsisting of identifying, assessing, minimizing,allocating, and implementing can be adopted.Activities in any one of these areas are affectedby activities in the others and usually proceed inparallel.

Identifying potential environmental andresettlement risks and opportunities

The process of identifying environmental andresettlement risks and opportunities must beginat the earliest stages of project development, andit must continue throughout the life of the pro-ject. As new parties become involved in thetransaction, they should be brought into theprocess. Once the government has identiÞed itsgoals for the infrastructure investment, it shouldundertake the initial analyses during prepara-tion of terms of reference. In the case of an unso-

contingencies that may arise over the course ofa twenty-year concession, the parties mustdevelop a strong working relationship based onrespect and understanding of each otherÕs goals.Experience developing such working relation-ships is now beginning to emerge from earlierprivatization efforts, such as that in BuenosAires (box 5.10).

Since public opposition is often the mostunpredictable and worrisome risk facing infra-structure projects, the public must be involvedin the risk mitigation process early and often.Such involvement can provide early warningconcerning project features that might lead toopposition, which could then be redesigned tominimize such risk, and help establish ongoingrelationships with the community, which allowthe sponsor to monitor and respond to newissues as they develop.

Public involvement is a sensitive, compli-cated, and uncertain process. In some countriespublic criticism of government-supported pro-jects is actively discouraged; in others there hasbeen little experience in soliciting public input.Identifying and reaching the various groups tobe consulted can be difÞcult. Deciding howmuch public involvement is enough and what

Box 5.10 Developing a good working relationship inBuenos Aires: Aguas Argentinas and ETOSS

Aspects of the 1993 privatization of the Buenos Aires watersystem demonstrate the importance of clearly defined rolesand long-term working relationships. Clear standards of per-formance were established and a pricing structure thatencourages efficient operation was adopted. A regulatorybody, ETOSS, was created to oversee the activities of theconcessionaire, Aguas Argentinas, and a variety of proce-dures are being used to resolve disputes between the par-ties. More important, however, as the concession goes oneach party is beginning to understand the other’s goals andmethods of operation more clearly. As the parties workthrough the wide variety of issues that arise through dailyoperations, a track record is being established that helpsbuild trust. As Aguas collects and makes available to govern-ment authorities more data on regional environmental con-ditions, the government is more likely to seek input from thecompany on regional environmental planning. While thismay eventually raise questions of “regulatory capture,” itprovides the parties with a basis for cooperating to resolveproblems they both face.

Box 5.11 Working cooperatively on resettlementissues in Calcutta

The original plan for construction of a 500-megawatt ther-mal power plant on the outskirts of Calcutta required mov-ing 200 families (800 people) from the site of the generatingstation and railway line. Representatives of the affected fam-ilies as well as of local, regional, and national governmentbodies worked with the Rehabilitation Committee to facili-tate the planning and implementation process. As a result oftheir efforts the project was redesigned so that only 100 fam-ilies had to be moved. The IFC provided financial and othersupport to the project, construction of which began in 1993.


licited bid, the sponsor should do so. Once theconcession has been awarded, the processshould continue jointly between the govern-ment and the sponsors, with the involvement ofÞnanciers before closing. The project operatorshould then carry the effort forward, with inputfrom the government and the affected public.

One of the Þrst steps will be the commission-ing and execution of some form of EIA, oftenaccompanied by or incorporating resettlementissues (box 5.12). Such reviews are almostalways required under national law and bydevelopment banks. Where private developersare involved, they are usually responsible forpreparing the EIA. Failure to conduct an ade-quate EIA provides project opponents with apowerful device with which to delay the project,as demonstrated by experiences in Malaysia, theUnited States, and Europe.

Once the EIA has been conducted, othertypes of risk of concern to private investors canbe identiÞed. For legal risks all applicablerequirements must be identiÞed and their likeli-hood of being met assessed. Performing such anassessment requires both legal and technicalskills and is usually handled by local and inter-national law Þrms working closely with engi-neering consultants. In many countries it isdifÞcult to Þnd local lawyers familiar with bothenvironmental requirements and the needs ofprivate investors. As both local and interna-tional law Þrms gain experience with theseissues, however, these difÞculties are diminish-ing. The sponsorÕs advisors usually take the leadon these issues, subject to conÞrmatory analysisby the lendersÕ advisors.

Identifying operational risks requires assess-ment of the technical and managerial capacity ofthe project to meet the required standards. ThesponsorÕs personnel, working closely with itssuppliers, will prepare a plan for doing so. Theirplan is then reviewed by the governmentÕs tech-nical consultants and then by technical consul-tants retained by the lenders. Many engineeringÞrms are qualiÞed to review these plans,although the different cost pressures facing thedesign and operation of privately Þnanced facil-ities may make assessments difÞcult for con-sulting engineers whose only experience is onpublic sector projects.

The methods for identifying political risksÑparticularly the likelihood of signiÞcant publicoppositionÑare the least well deÞned, becausethe issues themselves are less clear. The Þrst stepis for international sponsors and lenders toengage in a broad effort to try to understand thecountry and its politics, goals, and needs.Sponsors then work with government ofÞcialsto identify the risks facing a particular project.

Public outreach is an extremely importantpart of this effort. Ideally, such efforts begin withthe EIA. The basic features of an outreach pro-gram include the following:

¥ Identifying affected groups (both local andinternational) through contacts with govern-ment, community, environmental, religious,business, and other organizations

¥ Providing notice of the proposed project,including a project description, throughmedia bulletins, local project ofÞces, inter-ested organizations, and community meet-ings

¥ Offering opportunities for concerned citizensto submit comments on the project throughwritten remarks, surveys, individual inter-

Box 5.12 Checklist of potential issues for anenvironmental analysis

The International Finance Corporation’s guidance to staff on“Environmental Analysis and Review” identifies the followingareas:• Agrochemical usage• International waterways• Biological diversity• Involuntary resettlement• Coastal and marine resource management• Land settlement• Cultural properties• Natural hazards• Dams and reservoirs • Occupational health and safety• Environmental guidelines• Ports and harbors• Hazardous and toxic materials• Tropical forests• Indigenous peoples• Watersheds• Induced development/sociocultural aspects• Wetlands• Major hazards• Wildlands.

views, focus groups, and public meetings¥ Analyzing and developing responses to the

comments received, by making changes tothe project or explaining why requestedchanges will not be made

¥ Disseminating the responses to the affectedgroups through media bulletins, local projectofÞces, interested organizations, communitymeetings, and revised project descriptions

¥ Engaging in an ongoing process of providinginformation and receiving public input onthe project, through local project ofÞces,mailings, community meetings, and citizenadvisory boards.

Assessing the signiÞcance of particular risks

After environmental and resettlement risks andopportunities are identiÞed their signiÞcance tothe project needs to be determined. First, a roughorder of magnitude must be estimated for theÞnancial implications of each risk or opportu-nity. In some cases this is a relatively easy task;in other cases assigning a Þnancial value is com-plicated. For example, it is difÞcult to determinethe cost of the delays incurred as a result of dis-turbances at sites with local historical or reli-gious signiÞcance. Measuring and valuing theseimpacts can be difÞcult. Doing so is necessary,however, to give both government sponsors andprivate investors a basis for deciding whether ornot to proceed with the transaction.

Second, the available estimates are comparedwith the value of the deal as a whole or the ulti-mate costs to users. Although the cost of miti-gating a risk or capturing an opportunity mayseem large in absolute terms, it may represent aninsigniÞcant amount in the context of the over-all deal. Calculating possible impacts on userfees or investorsÕ return allows sponsors and thegovernment to decide whether or not to go for-ward and to focus their efforts on those risks andopportunities with the greatest potential impacton the deal.

Capturing opportunities and mitigating risksduring project design

The most effective time for governments andprivate investors to consider environmental and

resettlement issues is at the earliest stages of pro-ject design. By including environmental andresettlement goals from the beginning, govern-ments can bring private sector creativity to thedesign of cost-effective solutions. Privateinvestors are most comfortable when clearinvestment targets are presented and signiÞcantrisks can be eliminated through careful projectdevelopment.

In order to make the most of the projectdesign phase, governments must pay specialattention to their overall infrastructure goalsand the range of methods for meeting them, theenvironmental regulatory framework adoptedfor the project, and the plan to be developed andfollowed for addressing any involuntary reset-tlement issues.

Infrastructure goals and alternative methods formeeting them. Government infrastructure plan-ning has historically focused on large, high cap-ital cost facilities, often designed withoutsubstantial attention to environmental or socialimpacts. As governments seek to increase theprivate sector role in such projects, they oftenuse these prior infrastructure planning effortsand assumptions as the basis for bids and otherprivate involvement.

By relying on earlier planning efforts, gov-ernments often miss out on opportunities toapply private sector resources and creativity tothe cost-effective attainment of environmentaland development goals. This is true for twomajor reasons. First, only relatively recentlyhave environmental and resettlement issuesbegun to have a major impact on infrastructureplanning efforts. Second, while the private sec-tor can often meet many of the governmentÕsinfrastructure goals more cost effectively andmore reliably, its ability to do so is severely con-strained if it is limited to working within theconÞnes of early public sector plans.

To capture opportunities for improving envi-ronmental or social conditions through privateinvolvement, governments need to take twosteps. First, they should assign higher priority toa wider range of environmental and resettle-ment goals. These targets can then be includedin the optimization process for developing alter-native approaches to meeting infrastructure


needs. Clean water is already a priority for mostcountries in East Asia. Greater priority shouldbe given to increasing the efÞciency of poweruse and controlling dust and acid gas emissionsfrom thermal power stations. Opportunities forancillary environmental beneÞts for highwayprojects should be valued more highly. In casesof involuntary resettlement, alternatives thatminimize the numbers of people moved or max-imize the social gains to those affected should beweighted more heavily.

If governments set environmental and socialtargets, private investors will respond withmethods and prices for meeting them, providinggovernments with a measure of the cost ofachieving these targets. Broader considerationof environmental and resettlement goals willalso help reduce the potential for local and inter-national public opposition. In turn, this willexpand the pool of potential international fund-ing sources.

Second, governments need to be willing andable to consider a wider range of methods formeeting their goals. The clearer governments canbe about goals and the more ßexibility they canleave the private sector to design methods formeeting them, the more likely the private sectoris to come up with cost-effective solutions.Choosing among a range of options, however,requires a broader range of skills than thatdemanded by the traditional approach of puttinga publicly designed power plant out to bid.

Allowing the private sector leeway in devel-oping solutions may lead to recommendationson different aspects of projects:

¥ Types of projects: If the goal is to make 800megawatts of power available, a combinedoffer to provide 700 megawatts of new gen-erating capacity with 100 megawatts of mea-surable energy conservation gains mightbetter meet the joint power and environmen-tal goals at a lower cost.

¥ Locations for projects: It may be possible toreconÞgure the design of hydro facilities ortransportation corridors in order to minimizethe amount of land affected or the need forresettlement.

¥ Technical designs: Both Aguas Argentinas (theoperator of the privatized water and sewer-age system in Buenos Aires) and the Indah

Water Konsortium (the national sewerageconcessionaire in Malaysia) were able todesign sewerage systems that met the per-formance standards set by the governmentfor much less than estimated in earlier gov-ernment plans.

¥ Operating practices: Experience with coalwashing in the United States and Australiademonstrates that substantial economic andenvironmental beneÞts can be achieved as aresult of reduced ash content (reducing bothtransportation costs and emissions) andincreased combustion efÞciencies (China isseeking to increase the amount of coal itwashes from 24 percent to 30 percent by theend of the century).

¥ Financing packages: The $30 million grantfrom the Global Environment Facility to theLeyte-Luzon geothermal project in thePhilippines is one example of the publicÞnancing beneÞts that can accompany thedesign of projects with an increased Òenvi-ronmental incrementÓ (see box 5.8).The choice of projects still rests with the gov-

ernment. Recognizing and making explicit thetrade-offs made in the Þnal selection of a projectis an important part of the process of minimiz-ing public opposition. In some cases the impor-tance of a particular project for meeting thegovernmentÕs goals must be made clear in order


Box 5.13 Adopting a demand side managementapproach to energy efficiency in Thailand

In 1991 Thailand became the first Asian country to adopt autility-sponsored demand side management (DSM) energyefficiency program. A 1995 review of the potential for invest-ment in Thailand’s energy efficiency industry by theInternational Institute for Energy Conservation documentsthe wisdom of this initiative.

On average Thai investments in increased energy effi-ciency cost less than half the price of new generating capac-ity for the same level of megawatts. An achievable DSMpotential of at least 2,000 megawatts over the next decadehas been identified—25 percent of planned system expan-sion. As much as $2.3 billion in capital costs could be savedif an aggressive program to capture 2,000 megawatts of peakdemand was in place. Foreign operators with extensiveexperience with DSM programs in other markets (especiallythe United States) can readily bring this knowledge to bearin Thailand, helping to capture these opportunities.

to secure international Þnancial backing. Theproposed $1.2 billion Nam Theun IIhydropower project illustrates many of theissues facing efforts to increase private involve-ment in politically sensitive ÒspotlightÓ infra-structure projects (box 5.14).

Environmental regulatory frameworks.Governments need to establish and work withinclear, predictable, and reliable frameworks foroverseeing private sector environmental perfor-mance. Clear rules allow investors to price anddesign projects to reßect environmental con-cerns. Governments can then decide if the costof compliance is too high. If the rules are notclear or if they are inconsistently applied, pri-vate investors will assign a higher risk premiumto environmental issues, resulting in higher thannecessary project costs.

An ÒidealÓ environmental regulatory frame-work for an infrastructure project consists of anintegrated package of laws and contracts thatspeciÞes the following:

¥ Standards of performance (set in terms ofsimple emission limits and other readilymeasurable factors) that leave the privateoperator the ßexibility to determining how tomeet the standards

¥ Relationship of current and future environ-mental performance standards to the leveland regulation of user fees, particularly inlight of fees previously charged (or not) bythe government for such services

¥ Environmental review procedures to be fol-lowed

¥ Administrative procedures to be followed bythe government in deciding on authoriza-tions for the project, including mechanisms


The Nam Theun II project is designed to export 681megawatts of power to Thailand in return for much neededforeign exchange. Gross revenues to the Lao government areexpected to rise from $10 million to well over $100 million ayear (in constant 1994 dollars) over the twenty-five-year con-cession term, doubling foreign exchange earnings and increas-ing GDP by 20 percent.

The new dam would flood approximately 450 square kilo-meters, 30 percent of which is forested and rich in biodiversity.In addition, 900 poor households would need to be relocatedfrom the reservoir area. Several thousand people in the catch-ment area, along the reservoir perimeter, and in the down-stream channel area would also be affected by the project.

These environmental and resettlement problems haveflamed local and international opposition to the project.Environmental organizations have opposed the loss of forestson the Nakai Plateau; others have protested the resettlementplans. The intensity of these objections has been increased bythe international spotlight on large hydropower projects in Asia(Three Gorges, Narmada, Bakun) as well as by the protestsover implementation of the environmental mitigation plan forthe Pak Mun hydro project in Thailand.

The project is also financially risky. The projected cost isequivalent to about 75 percent of the country’s 1994 GNP andneither the Lao People’s Democratic Republic nor the privatesponsors (Transfield of Australia, Electricité de France, andItalian-Thai and Phatra Thanakit of Thailand) have the resourcesto undertake the project alone. International finance is thusnecessary. Crafting a project attractive to internationalfinanciers requires that environmental and resettlement issuesbe addressed in a manner acceptable to the international finan-

cial community. In most industrial countries, private investorswill not invest without development bank support; the WorldBank cannot provide that support unless environmental andresettlement issues are addressed to its satisfaction.

To address these concerns, the government needs tomake clear why hydropower is critical to meeting the devel-opment needs of both the Lao People’s Democratic Republicand Thailand and why it opted to develop hydropower ratherthan other sources of power, such as nuclear or coal-fired sta-tions.

The project also needs to be designed to optimize eco-nomic and environmental/resettlement benefits over the longterm. This will require a commitment by the Lao governmentto ensure implementation of the environmental and resettle-ment programs. Efforts are underway to offset the loss offorests in the flooded area with much greater protection of alarger forest preserve within the project’s catchment basin. Inaddition, a more extensive resettlement plan is being consid-ered that would allow the local population to share in the eco-nomic benefits of the project. Taking such efforts together, theproject may result in more effective protection of a large tractof rain forest.

All of these issues are now under consideration by projectsponsors and the government. Support for the project hasbeen received from two international environmental NGOs(the Wildlife Conservation Society and the World ConservationUnion) and the possibility of involving United NationsDevelopment Programme’s local office in the outreach neces-sary for development of the resettlement plan has been dis-cussed.

Box 5.14 Addressing the concerns of the international financial community over the Nam Theun hydroelectricproject in the Lao People’s Democratic Republic

for contesting aspects of the governmentÕsdecision

¥ Monitoring, reporting, and inspection proce-dures to be followed, including the role (ifany) of the public and NGOs

¥ Sanctions to be applied in the event of non-performance or environmental damage,including identiÞcation of all parties thatmay impose the sanctions, the procedures fordoing so, and the mechanisms for contestingthe sanctions

¥ Remedies available to the private operator, ifany, in the event the government changesenvironmental standards in the future.Given such a framework private investors

can build environmental considerations intoproject design, internal environmental manage-ment systems, community outreach programs,subcontracts with suppliers, insurance, andother project components.

Requiring private investors to meet suchstandards need not mean that projects will betoo expensive or will fail to attract investors. Infact, two of AsiaMoneyÕs 1995 Project FinanceÒdeals of the yearÓ were power stations that suc-cessfully met the environmental standardsapplied by both the national governments andthe U.S. Export-Import Bank (box 5.15).

Resettlement plans. Reducing the risk of pub-lic opposition through fair and equitable treat-ment of the affected populations should be thecornerstone of risk management from a projectÕsinception. Minimizing risks to investors goeshand in hand with minimizing risks to peopleaffected by the project.

The process should begin with a clear deÞn-ition of the tasks and responsibilities assigned todifferent parties in the deal. This can be donethough a combination of national laws and con-tracts. The resulting package of responsibilitiesshould cover the following areas:

¥ Preparation of the resettlement plan, includ-ing the items to be covered and standards tobe followed in doing so

¥ Acquisition of the land to be taken for boththe project and the relocated people

¥ Relocation of the affected people¥ Economic rehabilitation of the affected peo-

ple, both those relocated and those otherwise

affected by the project¥ Monitoring and supervision of implementa-

tion of the resettlement plan¥ Mechanisms for resolving disputes on reset-

tlement matters, including those between thegovernment and the affected people andthose between the government and the pri-vate sponsors or investors.Where truly voluntary resettlement (wholly

consensual purchases of the necessary land atopen market prices) is involved, the privatesponsors of the project will be able to take thelead in relocating the affected parties. Whereinvoluntary resettlement is involved, however,governments need to take the lead, especially incases involving involuntary resettlement oflarge numbers of people, including squattersand indigenous peoples. Private investors areless equipped to handle involuntary resettle-ment issues because they are often unfamiliarwith local conditions and lack credibility amongthe local population. Moreover, the politicalrisks of leaving involuntary resettlement in pri-vate hands are considerable and could increasethe level of resettlement payment.


Box 5.15 Meeting the environmental standards ofthe U.S. Export-Import Bank: The Paiton I(Indonesia) and Sual (Philippines) power projects

Two large power projects were financed with the help of theinternational financial community. No significant publicopposition to the projects was raised and all of the interna-tional institutions involved were satisfied that environmentalstandards had been met.

The $2.5 billion Paiton I project involves two baseload615-megawatt coal-fired power units in northeast Java,Indonesia. The U.S. Export-Import Bank (U.S. ExIm) pro-vided political risk cover for a $540 million loan. The U.S.Overseas Private Investment Corporation (OPIC) provided$200 million in financing. The $1.35 billion Sual projectinvolves a 1,200-megawatt coal-fired station in thePangasinan province of the Philippines. U.S. ExIm guaran-teed more than $370 million in debt, and the InternationalFinance Corporation (IFC) provided both direct loans andsyndication of commercial bank debt.

U.S. ExIm, OPIC, and IFC all apply their own proce-dural and substantive environmental standards to the pro-jects they support. In addition, two of the commercial banksinvolved in these deals—Chase Manhattan and Citibank—confirmed that they look to such “world” standards for com-fort as part of their due diligence on the environmental risksfacing power projects.

International investors are extremely reluc-tant to commit Þnancing to a project until invol-untary resettlement issues are addressed, even ifthe government provides complete cover for theÞnancial risks posed. For example, at least oneinternational investor active in power projectshas decided not to pursue the Ib Valley projectin India, in part because the new project has revi-talized old, unresolved resettlement claims inthe area.

The forcible clearing of a site by the govern-ment is not likely to address internationalinvestorsÕ concerns, particularly when viewedover the life of a long-term concession, becauseof the increased likelihood of up-front delaysand negative publicity for the project, the cre-ation of local ill-will (and the possible effect onthe future level and collection of user fees), andincreased long-term risks to project facilities,particularly along lengthy corridors.

Lessons from government efforts to addressthe risks of involuntary resettlement can befound in the World BankÕs 1994 resettlementreview, in which the Bank reviewed resettlementexperience in 192 projects it Þnanced between1986 and 1993, with a combined displacement of2.5 million people (box 5.16). The InternationalFinance Corporation (IFC) conducted a similarreview in 1995. Interestingly, the IFC had beeninvolved in only seven resettlement projects,affecting only about 2,500 people. Virtually all ofthe IFCÕs projects involved private sponsors

leading voluntary resettlement efforts at negoti-ated market prices.

These and other experiences with involun-tary resettlement suggest that the governmentneeds to develop and implement, with inputfrom affected parties, a resettlement plan thataddresses public concerns while meeting gov-ernment and investor goals. To do so, the gov-ernment should take the following steps:

¥ Coordinate development of and commit toimplementing a comprehensive resettlementplan (with support from private sponsors).

¥ Begin community outreach as early as possi-ble, preferably before a Þnal siting decision ismade, and involve local groups in the com-munities the affected people will be movingfrom and to.

¥ Consider how to address the different needsof the parties being relocated, particularlyproperty owners, squatters (including laterwaves of squatters), and indigenous peoples.

¥ Develop plans to address both the replace-ment of housing (either directly or throughpayment of compensation) and long-termincome restoration (through jobs on the pro-ject and training, for example).

¥ Seek opportunities to upgrade local infra-structure, housing, landscaping, and similaramenities as part of the resettlement pack-age.

¥ Establish adequate mechanisms for recourseby affected parties that wish to challenge the


Involuntary resettlement is almost always more difficult, moreexpensive, and more time consuming than governmentsexpect, according to the World Bank (1994). Several factorsappear to explain the differences between successful andunsuccessful resettlement efforts:

1. Strong political commitment: The adoption of legalframeworks and guidelines (regional or sectoral) forresettlement is an early expression of political com-mitment. Conscientious and timely implementationof those rules (particularly the payment of compen-sation or provision of replacement land) confirms thatcommitment.

2. Focus on income restoration: Creating the conditionsfor successful income restoration is critical to reset-tlement efforts. Achieving this goal is enhanced whenthe affected parties share in the immediate benefits ofthe project. Moving affected parties to newly pro-

ductive areas created by the project, favoring them inproject hiring and ancillary developments, and assist-ing them in building improved housing will help miti-gate the adverse effects of these people.

3. Accurate costing and financing: Poor performance onresettlement was often traced to inadequate eco-nomic analysis, externalization of re-establishmentcosts onto the affected population, and underfinanc-ing. In the twenty cases reviewed, resettlement costsaveraged 9 percent of appraised costs and went ashigh as 35 percent.

4. Participation of the affected parties: Outreach is criti-cal to inform affected populations of the possibleneed to resettle and to obtain their input on sustain-able solutions to resettlement. Doing so often sub-stantially decreases the likelihood of major publicopposition.

Box 5.16 Major findings of the World Bank resettlement review

government action.¥ Prepare complete and accurate cost estimates

for the full resettlement plan.¥ Secure adequate Þnancing (from both public

and private sources) for different compo-nents of the plan.

¥ Adopt community-based mechanisms formonitoring and implementing the plan.Once the government takes these steps, pri-

vate parties can make technical, operating, andÞnancial support available for different parts ofthe plan at different times.

Allocating residual risks to the parties best able tomanage them

While the goal of risk management is to elimi-nate as many risks as possible during design,signiÞcant risks always remain. Residual risksneed to be allocated to the parties in the bestposition to manage them. This is usually donethrough the contracts that comprise the projectand Þnancing documents.

Environmental and resettlement risks areallocated among the government, project spon-sors (including their subcontractors), develop-ment banks, and private investors (table 5.3).

Different parties are best able to manage par-ticular risks. Private parties are well positionedto address risks involving technical and opera-tional issues and to provide support for com-munity relations activities. Governments arebest placed to bear political risks, including therisks associated with many aspects of resettle-ment. Development banks can provide technicalassistance and direct support in the event of sig-niÞcant international public opposition as wellas guarantees of government obligations undercertain circumstances. Private Þnanciers areextremely risk averse and will want essentiallyall project risks allocated to other parties beforeproviding funding. After the deal is signed, pri-vate Þnanciers will monitor only those issueshaving an obvious and direct impact on bor-rowerÕs Þnances or a potential impact on theirother operations. However these responsibili-ties are allocated, assignment of risk needs to beclear. Risks should not remain unaddressedbecause they were unassigned in the contract.

A clear process for responding to unantici-

pated risks also needs to be in place. Much of thesuccess of such efforts will stem from the qual-ity of the relationship established between thegovernment and the sponsors. In addition, thecontracts and regulatory framework shouldspell out clear mechanisms for identifying key,unresolved issues, resolving issues at higher lev-els of management, and using arbitration orother mechanisms to resolve outstanding issues.

Implementing risk management programs

From a private investorÕs perspective, failing toimplement a risk management program is just asbad as not having developed a plan in the Þrstplace, as it gives opponents grounds on which toattack the project. Protests over the performanceof the Pak Mun hydropower project in Thailand(including the alleged negative impact on theÞshing industry and the poor implementation ofthe environmental mitigation plans) demon-strate these difÞculties.

Conclusion

The environmental and resettlement issuesassociated with infrastructure projects repre-


Box 5.17 Resettlement lessons from China

In its 1994 review of government-sponsored resettlementefforts, the World Bank concluded that “resettlement inChina is now generally considered to work well and evenadds to project benefits” (page 4/16). Four major reasonswere given by the Bank for this apparent success:

1. Incentives: Resettlers receive strong incentives tomove, ranging from increased living space to sig-nificant compensation payments.

2. Decentralization: Responsibility for resettlement,including development and implementation, is atthe local or city government level.

3. Institutional policies and procedures: China hasadopted binding policies and procedures for agri-culture, energy, and urban development projects,expenditures on which are reviewed by nationalauditors.

4. Giving resettlers a stake: Resettlement efforts hingeon providing productive resources to new com-munities, with many communities using theopportunity to launch new enterprises they previ-ously could not afford.

sent both risks and opportunities. The challengefacing governments is to bring the power of theprivate sector to bear on priority environmentaland social issues. For many government ofÞ-cials this will require a change in the traditionalview that economic development and environ-mental protection are fundamentally inconsis-tent with each other. This view leads to effortsto exclude environmental considerations fromthe goals of development policies, includingplanning for infrastructure projects. The resultis projects that lack clear guidance for investorson environmental issues and that are morelikely to attract public opposition. Similar prob-lems often accompany resettlement issues, par-ticularly where indigenous peoples or squattersare affected.

The Þrst step in meeting this challenge is toconvince development ministries that it is intheir best political interest to take environmen-tal and resettlement issues seriously from thevery beginning of infrastructure planningefforts. Doing so can improve the health andproductivity of local citizens, reduce the uncer-taintiesÑand hence costsÑfacing privateinvestors, and extend the efÞciency gains fromprivate involvement in infrastructure services.Private investors will participate in projects witha higher environmental or social content if thetargets are clear. Governments will know thetrue costs of such alternative approaches only ifthey solicit bids based on meeting environmen-tal and resettlement targets.

The second step is to build the capacity ofgovernments to evaluate and oversee private

activity aimed at meeting environmental andsocial targets. Private companies will meet onlythose targets that have a signiÞcant impact ontheir commercial interests. If governments settargets but have no basis for evaluating privateproposals to meet them, the effort will fail.Effective mechanisms for monitoring perfor-mance must also be in place.

Setting, evaluating, and enforcing targets forprivate sector activity are among the core activi-ties of governments in their changed role in infra-structure. Including environmental andresettlement considerations among the priorityfactors to be optimized during infrastructureplanning will help ensure that opportunities arecaptured, risks mitigated, private investmentincreased, and development beneÞts maximized.

Notes

1. Example include the Bakun and Nam Theun IIhydropower projects, the Malaysian sewerage conces-sion, and the Bangkok and Manil light rail projects.

References

International Institute for Energy Conservation. 1995.ThailandÕs Energy-Efficiency Industry: Potential forInvestment. Washington, D.C.

World Bank. 1994. Resettlement and Development: TheBankwide Review of Projects Involving InvoluntaryResettlement. Washington, D.C.

ÑÑÑ. 1995. Mainstreaming the Environment.Washington, D.C.


Table 5.3 Responsibility for residual environmental and resettlement risks

Risk Host country Sponsor Development banks Private financiers

Meeting legal standardsEnvironment 1 3Resettlement 1 2 3

OperationalTechnical 1Managerial 1

PoliticalLocal opposition 1 1 2 3International opposition 1 1 2 3Fee collection 1 2 2 (if guaranteed) 3Change in law 1

Note:1= party usually takes the lead in addressing or bearing risk2= party often bears a portion of the risk and works actively to address it3= party usually provides technical support on or actively monitors the level of the risk borne by other parties

The infrastructure requirements of East andSouth Asia are very large and are increas-ing rapidly because of strong economic

growth. Countries throughout the region haverecognized that the public sector is unlikely tomobilize the required resources and that the pri-vate sector must be brought in as a supplemen-tary source of Þnance. Private sectorparticipation in infrastructure is desirable notonly to ensure a larger ßow of resources but alsoto introduce greater efÞciency in the supply ofthese services.

The explosion of global capital markets andthe associated expansion of private capital ßowsto emerging market economies provides newopportunities to Þnance infrastructure projectsin these countries, provided projects can bemade commercially viable. Several experiencedinternational companies are interested in invest-ing in infrastructure development in Asia pro-vided the overall investment climate isperceived as attractive, and many countries inthe region have domestic entrepreneurs keen toenter these sectors.

Despite these apparently favorable circum-stances, the experience in introducing privateinvestment into infrastructure development hasbeen mixed at best. There have been somenotable successes in East Asia, but the pace ofimplementation in many countries, especially inSouth Asia, has been much slower than was ini-tially expected. Interestingly, the slow pace hasnot reßected the lack of private capital.Although the resources available are probablyinadequate to meet all of the infrastructureneeds of the region, which are indeed enormous,

fewer private sector projects are currently beingÞnanced than are feasible with current levels ofresource availability. In other words, the opera-tive constraint is not the level of resource avail-ability but the ability to structure projects in amanner suitable for private Þnancing.

This chapter examines the reasons why somany developing countries have experienceddifÞculties in implementing private sector infra-structure projects. It focuses on problems asso-ciated with (a) the fact that infrastructureprojects are generally subject to tariff regulation,which presents special problems for privateinvestment; (b) the nature of the risks associatedwith infrastructure projects and the consequentneed for complex risk mitigation arrangementsto ensure Þnanceability; and (c) the need tomobilize a suitable mix of Þnance, especiallylong-term Þnance, which is not easily obtained.

The problem of tariff determination

Tariffs on all infrastructure projects are regu-lated; private operators are not free to Þx oradjust tariffs at will. The tariff is typically Þxedin advance and adjustable over time only inaccordance with predetermined contractualterms. Private investment can be attracted into atariff-regulated sector only if investors are con-vinced that tariffs will be set and periodicallyadjusted in a manner that ensures an adequaterate of return to investors. Equally important,the public utility character of infrastructure pro-jects requires that the tariff be perceived as ÒfairÓto consumers. This balance is not always easy tostrike, and disputes over tariffs can delay project

87

Montek S. Ahluwalia

6 Financing Private Infrastructure:Lessons from India


implementation. Some of the alternative ways ofÞxing remunerative tariffs, and the problemsassociated with them, are discussed in the fol-lowing sections.

Cost-based tariffs

The traditional approach to Þxing tariffs that areboth remunerative and reasonable is to tie thetariff to normative levels of costs per unit forgiven levels of capacity and production. Thesecost-based tariffs cover capital costs on the basisof approved levels of capital expenditure andvariable costs on the basis of speciÞed parame-ters of operating efÞciency. They also include acomponent for return on capital, which is cali-brated to yield an acceptable rate of return toinvestors at a reasonable level of capacity uti-lization and operating efÞciency. Cost-based tar-iff formulas generally include explicitprovisions for adjustment of tariffs over time toreßect rising prices.1 This cost-based approachto utility pricing has been used to price electricpower supplied by independent producers to amonopoly distributor. It has also been used todetermine tolls for roads, bridges, and bypasses.

The cost-based approach has many prob-lems. From the point of view of the producer, theattractiveness of the tariff depends on whetherthe rate of return on equity generated by apply-ing the cost-based formula is sufÞciently remu-nerative for investors. Experience suggests thatprivate investors in infrastructure projects indeveloping countries typically expect rates ofreturn on equity of 20Ð25 percent. This is muchhigher than the rates of return normally used fordetermining public sector tariffs. China initiallycapped rates of return in the power sector at 15percent, deterring many investors. The cap hassince been relaxed. In India the rate of returnnormally used to Þx tariffs for public sectorpower producers is 12 percent after tax. In orderto attract private investment the return onequity was raised to 16 percent at 68.5 percentcapacity utilization, with incentives that yieldedadditional returns of 10Ð12 percentage points forcapacity utilization of 85 percent. However, inthe Indian tariff formula these rates of returnaccrue only from the date of commercial pro-duction; no return accrues during construction.

The internal rate of return on equity, which takesaccount of the lack of return during the con-struction period, is therefore much lower.Private power producers have accepted this for-mula only because the operational efÞciencynorms used in computing variable costs are rel-atively lax and most private power producersexpect to improve on these norms, therebyachieving internal rates of return of more than 20percent. The formula has been criticized on thiscount as being nontransparent.

Cost-based formulas are generally vulnera-ble to the criticism that the approved capitalcosts are excessively high or the efÞciency normsexcessively lax. There is no transparent way ofcountering this criticism. Estimates of capitalcosts are especially difÞcult to defend againstsuspicion of cost padding or Ògold platingÓ ofcapacity. This problem is especially acute whenequipment suppliers belong to the project spon-sor group. Comparison with costs of other pub-lic sector projects is one way of determiningwhether costs are appropriate, but such com-parisons ignore differences in technology andquality. For example, high capital costs in pri-vate sector power projects may be associatedwith greater fuel efÞciency, which reduces thepower tariff. All these issues, as well as issuesconnected with risk mitigation, have surfaced inone form or another in the public debate over thecost of private power in India (box 6.1).

Fixing tariffs through competitive bidding

An alternative approach to Þxing tariffs isthrough competitive bidding. Relevant techni-cal and production characteristics of the projectare speciÞed in advance, and qualiÞed biddersare asked to bid in terms of the lowest tariff atwhich they would be willing to undertake theproject. As in the case of cost-based tariffs, thesetariffs have to be adjusted over time to reßectinßation, and the manner in which this adjust-ment will be made must be speciÞed in the invi-tation to bid. Under this approach cost paddingis not a problem, and there is a transparent wayof determining the lowest tariff at which the pro-ject can be implemented. If existing public sec-tor suppliers are also allowed to bidcompetitively, the approach establishes a level

Financing Private Sector Infrastructure 89

India announced a new policy for attracting private sectorinvestors in power generation in 1992. The policy envisagedbulk sale of power to the State Electricity Boards (SEBs) atnegotiated rates based on a cost-plus formula. A large numberof Memoranda of Understanding were signed, involving80,000 megawatts of additional capacity. Implementation hasbeen much more modest.

Problems of tariff determination and risk mitigation provedmore complex than envisaged at the time the policy wasannounced:

• The cost-plus formula was perceived as being vul-nerable to padding of capital cost. The same formulahad not attracted criticism earlier, when both gener-ating stations and distributors were in the public sec-tor, but the formula was felt to be unacceptable whenapplied to private sector projects. It became evidentthat much higher levels of due diligence are expectedwhen there is a public-private interface. The govern-ment has since announced that future projects will beawarded on the basis of competitive bidding.

• The policy did not originally envisage any guaranteesby the central government, but many privateinvestors were unwilling to accept assurances of pay-ment for power purchased by the SEBs because oftheir poor financial condition. Moreover, they werenot satisfied with guarantees given by the state gov-ernments and insisted on counterguarantees fromthe central government. The central governmentultimately decided to extend such counterguaranteesfor the first eight private sector projects.

• Private investors sought much greater risk mitigation

than public sector players had. Private investorslooked for exchange risk protection, assured off-takeof power subject to plant availability, protectionagainst fuel supply risk, and other risk mitigationschemes. These special features were criticized in thepublic debate as being excessively favorable to privatesector projects.

• The first power project sponsored by the EnronCorporation at Dabhol in the State of Maharashtraran into a series of hurdles, including renegotiation ofthe initial agreement, because of a change in the stategovernment. It also faced several legal challenges inpublic interest litigations, including challenges of thevalidity of environmental clearances. Fortunately,these obstacles, including twenty-five court cases,have been overcome, and the project is currentlyunder construction.

The complexities involved in achieving financeable pack-ages for private sector power projects were not adequatelyappreciated at the outset. As a result, resolution of problems,involving interaction with several government agencies, tooktime. The government ultimately appointed a high-level boardconsisting of senior representatives of the various ministriesinvolved to resolve problems.

Progress has recently accelerated. The 700-megawattEnron project at Dabhol is under construction, and two powerprojects have actually started generating power (the 235-megawatt GVK project at Jegurupadu in Andhra Pradesh andthe 208-megawatt Spectrum project at Kakinada in AndhraPradesh).

Box 6.1 India’s experience with the power sector

playing Þeld for the private and public sectorsand thus ensures least-cost supply for individ-ual plants. High rates of return realized byinvestors in a competitive bidding frameworkneed not attract controversy, since the biddingprocess ensures that the tariff is the lowest pos-sible. High returns under these conditions canonly reßect increased efÞciency, which should beencouraged.

One limitation of the competitive biddingapproach is that transparency in biddingrequires full speciÞcation of the minimum tech-nical requirements of the projects, which callsfor considerable advance work before bids aresolicited. Certain characteristics of the project,including basic technical speciÞcations and theexpected level of guaranteed supply, must bespeciÞed. Environmental regulations may also

impose certain conditions with which all bid-ders must comply. However, it is important toavoid overspecifying technical details to thepoint of foreclosing technology choices, whichare best made by private investors searching forleast-cost solutions.

Competitive bidding also has its limitations.A bidding process will yield the lowest costoption only if enough qualiÞed bidders activelycompete. In practice the number of bidders foran infrastructure project may be limited, for sev-eral reasons. Lack of information and clarityabout various aspects of government policy rel-evant to the project may deter many eligible bid-ders from bidding. This may occur if the legal,Þnancial, and technical requirements of the pro-ject are not spelled out in advance or there is lackof conÞdence that the integrity of the bidding


process will be maintained (that is, the predeter-mined requirements will not be changed afterbids have been solicited). In such situations Þx-ing tariffs through competitive bidding couldproduce an outcome inferior to that that couldhave been achieved through negotiations. AnInternational Finance Corporation study (1996)comparing tariffs in different power projects inIndonesia concluded that there was no evidencethat tariffs arrived at through competitive bid-ding were lower than tariffs Þxed through nego-tiation. The experience in the Philippines leadsto the opposite inference. Tariffs in the earliestpower projects, which were set on a negotiatedbasis, were as high as 8 cents a kilowatt hour; tar-iffs on the later projects, which were competi-tively bid, were as low as 5 cents a kilowatt hour.

In the Þnal analysis the relative merits of Þx-ing tariffs through competitive bidding or nego-tiation will depend on the quality of the biddingprocess in the one case and the quality of thenegotiating process in the other. Negotiationmay well yield a better outcome in some cases,but competitive bidding is more transparent, anoverwhelmingly important consideration ingovernment decisionmaking. On balance com-petitive bidding is superior to negotiation, andmost developing countries have adopted thisapproach where possible.

Regulated tariffs with competitive bidding

In many situations tariffs are not determined bycompetitive bidding but are Þxed by a regulatoryor other authority. In such cases competition canbe used to select the private investor by solicitingcompetitive bids in terms of the license feeoffered during the concession period or in termsof a revenue-sharing arrangement. This approachis particularly well suited to cases in which theindependent producer deals directly with theÞnal consumer and demand forecasts ensureproÞtable operation. In telecommunications, forexample, there is often signiÞcant unsatisÞeddemand at prevailing tariff levels, and newlicensees can expect to be proÞtable within a rel-atively short time.2 A similar situation mayobtain in port development, where capacity maybe visibly overstrained and private sectorinvestors may be willing to expand port facilities

or set up new competing ports, subject to a com-mon tariff Þxed by a regulatory agency. TheJawaharlal Nehru Port Trust in India has recentlyawarded a $200 million port expansion, involv-ing private sector construction and operation oftwo new container terminals, to an Australian-Malaysian joint venture through competitive bid-ding on the basis of revenue sharing.

The license fee or revenue-sharing approachcan be adopted wherever the licensee can makesufÞcient proÞt to be able to offer a license fee ora share in revenue. In other situations, such asconstruction of toll roads with low trafÞc pro-jections in the initial years, it is not possible toensure proÞtability with any plausible tariff formany years. In such cases private sector invest-ment is possible only if returns to investors canbe enhanced. The simplest solution is to offer anoperating subsidy, or an upfront capital subsidy,with the subsidy determined by investors bid-ding competitively for the lowest subsidy. A sec-ond approach is to bundle an existing publicsector asset into the concession to increase theproÞtability of the new investment. In India, forexample, the government has announced thatprivate investors will be invited to invest inwidening two-lane toll-free roads into four-lanetoll roads. The inclusion of the two-lane road,with its established trafÞc ßow, provides a largerand more certain return, making competitivebidding possible. A third approach is to includeother commercially proÞtable opportunities,such as commercial development of real estatein areas opened up by a new road, as part of theproject. This internalizes beneÞts generated bythe project, improving the attractiveness of theinvestment and making competitive biddingpossible. A variant of this approach is to delinkthe infrastructure component of the project fromthe exploitation of associated proÞt-makingopportunities and to solicit competitive bids foreach separately. Explicit subsidies can then beprovided for the infrastructure component,Þnanced by revenues realized from the prof-itable component. In Hong Kong, for example,the real estate development rights over each sta-tion on the rail link between the city center andthe new airport have been bid out competitively,and the revenues generated will be used toÞnance the airport.


Public acceptance of tariffs

Any of these methods of Þxing tariffs can ensureadequate returns to investors. More difÞcult isensuring that the resulting tariffs pass the test ofpublic acceptance. Private sector suppliers willoften require higher tariffs than those beingcharged in the public sector system, because pub-lic sector supplies of urban services, roads, andeven power, are typically heavily underpriced,reßecting large subsidies. The switch from under-priced public sector services to fully pricedÑandtherefore more expensiveÑprivate sector ser-vices can generate resistance from consumers.3

Higher-priced services from the private sec-tor may not be resisted if the private sector isseen as providing an additional, and perhapshigher quality, source of supply, with consumersretaining the choice to continue with the existinglower-quality public sector service. Introductionof a new privately operated toll highway as ahigher-priced but faster alternative to a publiclymaintained toll-free road may not evoke con-sumer resistance, for example. However, con-version of toll-free road into a toll road couldmeet with stiff resistance.4 The difference in con-sumer reaction to private entry into telecommu-nications and electricity generation in Indiaillustrates the problem. Consumers showed noresistance to the entry of new private sector cel-lular telephone service providers, which offereda higher-cost service that competed with theÞxed public sector phone service. In contrast, theentry of independent power producers sellingpower to the State Electricity Boards (SEBs),which then distribute power to Þnal consumers,did meet with some resistance. Although the tar-iff charged by independent power producers tothe SEBs does not directly affect the tariffcharged by the SEBs to Þnal consumers, therewas concern that reliance on higher-priced pri-vate sector power would raise the average costof the SEBs, which would eventually lead tohigher prices for consumers.

Is such consumer resistance justiÞed? Theanswer clearly depends on whether the cheaperpublic sector supply reßects greater efÞciencycompared with the private sector alternative ormerely reßects its subsidization by the govern-ment. In most cases low public sector tariffs

reßect large subsidies, either explicit (throughthe budget) or more often hidden (in the form ofpublic sector losses). Consumers pay for thesesubsidies in the form of higher taxation orreduced levels of expenditure on schools, publichealth, and other essential services, but thisimplicit payment is usually not recognized as acost. Public acceptance of higher tariffs from pri-vate sector projects therefore depends cruciallyon public realization that continuation of subsi-dized public sector tariffs is simply not feasible.This is indeed the case in most developing coun-tries, since the public sector cannot even ensurecontinued supply, let alone provide increasedsupply, at prevailing prices. Indeed, one of thecompulsions for seeking private investment ininfrastructure development is precisely the lackof public sector resources because of chronicunderpricing.

This is not to say that tariff increases by pri-vate sector providers should be uncriticallyaccepted. One of the arguments in favor ofinvolving the private sector in infrastructure isthat it is likely to be more efÞcient than the pub-lic sector, and it is important to ensure that theseefÞciency gains are achieved. The cost of ser-vices supplied by the private sector shouldtherefore be the lowest possible and should com-pare favorably with the real economic cost(excluding subsidies) of the public sector alter-native. At Þrst glance cost minimization can beensured by competitive bidding, but if compar-ison with the public sector alternative is animportant benchmark in ensuring public accep-tance, competitive bidding is effective only if thepublic sector also participates in the bidding.The experience of Hyderabad, India, in privatiz-ing the supply of drinking water is instructive inthis context. International bids were solicited fora $300 million urban water supply project, andthree bids were received. However, the cost ofthe lowest bid was found to be more than 60 per-cent higher than the estimated real cost (exclud-ing subsidies) if the project were to beimplemented by the public sector. The cityauthorities decided to reject all bids and opt forthe public sector alternative. Cost efÞciency ofprivate sector infrastructure projects, includingcomparison with the public sector alternative,must be a prime consideration in evaluating


such projects.

Risk mitigation and private Þnancing

All investment projects involve some risk, butinfrastructure projects in developing countriesare perceived as unusually vulnerable to risks,which constrains Þnancing. Risks are perceivedas high partly because projects are typicallyundertaken not by established utility companieswith strong balance sheets but by special pur-pose companies executing individual projectson a build-operate-transfer (BOT) or build-own-operate (BOO) basis. Project Þnancing is on anonrecourse basis (that is, lenders do not haverecourse to the sponsor company but look solelyto the revenue stream of the project available tomeet debt service obligations). The risks associ-ated with the revenue stream are therefore scru-tinized. Equity investors may be willing toaccept higher levels of risk in return for higherexpected returns on their equity, but lenders typ-ically have a lower tolerance for risk and agreater need for risk mitigation mechanisms.Although governments conduct project negoti-ations with the sponsors, it is the lenders behindthe scenes who set risk mitigation standards anddetermine whether projects are Þnanceable.

Unbundling different kinds of risks

The general principles for risk mitigation arewell known. The various risks involved shouldbe unbundled and assigned to the participantsable to manage them at least cost. Risks that canbe more efÞciently handled by agencies otherthan the project are shifted to these agencies,thereby reducing the residual risk borne by theproject. This process of shifting risks typicallyinvolves a cost, which is subsumed in the tariffby the sponsors. If risks have been efÞcientlyassigned to those best able to manage them, thecost of risk management is minimized and thetariff is a minimum-cost tariff.

The major risks involved, the methods forhandling these risks, and the problems that canarise in each case are discussed in the followingsections. Some of these risks are prevalent inmost investment projects. Many are particularlyimportant in infrastructure projects.

Construction risk. Construction risk refers tounexpected developments during the con-struction period that lead to time and cost over-runs or shortfalls in performance parameters ofthe completed project. High capital intensityand a relatively long construction period makeproject costs especially vulnerable to delaysand cost overruns. As a result construction riskis generally higher in sectors such as power androads and lower in sectors such as telecommu-nications and urban services.

Construction risk can be reduced through avariety of instruments. The reputation andexperience of the sponsors and the engineer-ing, procurement, and construction (EPC) con-tractor is an important element in assessingconstruction risk. Project sponsors can shift aportion of the construction risk to the EPC con-tractor through EPC contracts that provide forturnkey responsibility, with penalties fordelays and shortfalls in performance parame-ters of the plant on completion. Such perfor-mance guarantees add to the cost of the project.While construction risk can be shifted to someextent, it cannot be eliminated entirely, sincepenalties for nonperformance are typicallycapped at certain levels and the residual riskhas to be borne by investors. However, lenderswould be satisÞed with risk sharing thatreduces project risk to a level that can beabsorbed by equity investors without jeopar-dizing loan repayments.

Operating risks. The technical performanceof the project during its operational phase canfall below the levels projected by investors fora number of reasons. Operating risk is usuallylow for infrastructure projects that rely on atested technology, as is the case with mostpower plants and roads. It is higher in sectorsin which the technology is untried or is chang-ing rapidly, such as telecommunications.Operating risks are typically mitigated byentrusting operation to experienced opera-tions and maintenance contractors.Contractual arrangements with such contrac-tors can include some provisions for liquidateddamages. Many risks during the operationalphase, including certain force majeure risks,


are commercially insurable, and privateinvestors will typically insure against such risks.

One source of operating risk that is veryimportant in the power sector is fuel supply risk.Power projects are highly vulnerable to inter-ruption of fuel supply, and independent powerproducers generally seek to shift this risk to thefuel supplier or the purchaser. Private Þnancingof power projects depends critically on the abil-ity to negotiate satisfactory fuel supply agree-ments, with appropriate penalties payable bythe fuel supplier in the event of nonperfor-mance. Fuel supply problems are being tackledin different ways in different private sectorpower projects in India. The 700-megawattDabhol project in Maharashtra relies onimported naphtha, with the fuel supply riskborne largely by an international supplier. The235-megawatt gas-based GVK project in AndhraPradesh relies on natural gas supplied by thepublic sector monopoly supplier. In the event ofa fuel interruption, the supplier has the option ofswitching to more expensive imported naphtha,with the higher fuel cost Òpassed throughÓ to thetariff. In the 1,040-megawatt Visakhapatnamcoal-based power project in Andhra Pradesh,the fuel supplier, Coal India Ltd., is a govern-ment-owned company, and coal transportationdepends on Indian Railways, which is also gov-ernment owned. The fuel supply agreementswith Coal India Ltd. stipulate substantial liqui-dated damages, which cover the Þxed capitalcharges and expected returns upto certain lev-els, in the event of nonsupply. In the 1,000-megawatt Bhadravati power project inMaharashtra, the private producer is develop-ing a private sector captive coal mine to supplycoal to the project. The project sponsors are tak-ing on the fuel risk because fuel is being sup-plied by an associated company.

Market risks. Market risks relate to the possi-bility that market conditions assumed in deter-mining the viability of the project are notrealized. NonfulÞlment of demand projectionsis an obvious example of market risk. In certainsituations investors expect the monopoly pur-chaser to guarantee a minimum level of pur-chase, thus eliminating market risk for theinvestor. This is typically the case when an inde-

pendent power producer sells power to amonopoly distributor or a water supply projectsells water in bulk to a monopoly urban waterdistributing company. In other cases, such astelecommunications, ports, and roads, wherethe private producer deals directly with indi-vidual users and users typically face competingoptions, market risk is borne by the investor.Investors are expected to undertake marketstudies and satisfy themselves that marketdemand projections at feasible levels of tariffswould yield adequate proÞtability.

The situation in which no reasonable toll-cum-trafÞc projection can ensure proÞtabilitymust be distinguished from market risk, whichrefers to situations in which trafÞc is projected tobe adequate but there is considerable uncer-tainty in the forecast. Financial projections mustallow for downside possibilities. In these situa-tions project sponsors may expect the govern-ment to share downside risks throughguarantees involving payments to cover part ofthe earnings forgone if trafÞc falls below a cer-tain level. To ensure symmetry such guaranteescan be balanced by a corresponding sharing ofrevenues if trafÞc exceeds a certain level. In thisway part of the risk can be shifted to the gov-ernment. Although governments are normallyreluctant to offer such guarantees, they may wellrepresent the less expensive option if the onlyalternative is for the entire burden of uncertaintyto be borne by the government.

Interest rate risks. Interest rate risks arisebecause interest rates can vary during the life ofthe project. They are particularly important ininfrastructure projects because of the high capi-tal intensity and long payback periods. Highcapital intensity implies that interest costs rep-resent a large part of total costs; long paybackperiods mean that Þnancing must be availableover a long period, during which interest ratesmay change. One way of handling interest raterisk is to pass it on to consumers, as, for exam-ple, in arrangements in which the impact ofinterest rate variations on unit costs are treatedas a Òpass throughÓ into the tariff. In the cost-based tariff formula used in many power pro-jects in India, for example, interest costs are builtinto the tariff. Such an approach is neither nec-


essary nor desirable, however, since anyarrangement that automatically passes on thsescosts to consumers reduces incentives for costminimization. An alternative is to allow the riskto be borne by the investor, who in turn canhedge the risk through devices such as interestcaps and collars. The feasibility of this optiondepends on the sophistication of the relevantÞnancial markets and the availability of hedginginstruments. Typically, it is much easier to hedgeinterest rate risks in international markets thanin domestic markets, since domestic hedginginstruments are not available in most develop-ing countries. The cost of hedging would, ofcourse, have to be borne by the project andreßected in the tariff.

Foreign exchange risks. Two types of foreignexchange risks need to be distinguished. Onerelates to exchange convertibility, the assurancethat revenues generated in domestic currencycan be converted into foreign exchange for mak-ing payments abroad. This risk must be borne bythe government through suitable convertibilityguarantees. The other type of risk is exchangerate risk, the risk that exchange rate changes leadto large increases in the domestic currency costsof payments denominated in foreign currency.This risk is extremely important for infrastruc-ture projects that rely heavily on foreign Þnanc-ing but that have tariffs Þxed in domesticcurrency.

Exchange rate risk can be handled in differ-ent ways. When the tariff is Þxed in foreign cur-rency (as may be the case with port charges) orwhen it is automatically adjusted to reßect theimpact of exchange rate variation on those costcomponents that are denominated in foreignexchange, exchange rate risk is borne by con-sumers. In many cases, however, tariffs may beindexed only to domestic inßation, exposing theproject to the residual foreign exchange risk. It isnot easy to shift foreign exchange risk in suchcases. If long-term swaps between domestic andforeign currencies were readily available itwould be possible to hedge this risk at a cost.Such swaps are typically not available in mostdeveloping countries, however, partly becauseof inadequate market development and partlybecause of government policy. Hedging instru-

ments cannot develop as long as foreignexchange markets remain tightly regulated.

The absence of hedging instruments is notthe only problem. The inherent uncertaintyabout exchange rate movements in developingcountries is such that even if hedging instru-ments were to evolve they would be very expen-sive. The only way to reduce foreign exchangerisk in this situation is to limit the extent of exter-nal Þnancing. This in turn depends on the exis-tence of a healthy domestic capital marketcapable of providing sufÞcient domestic Þnanc-ing for infrastructure projects.

Payment risk. Investors in infrastructure alsoface the risk of not being paid for services deliv-ered. The importance of this risk varies acrosssectors. It is not very important in projects inwhich the sponsor deals directly with a multi-tude of consumers, as in the case of a telephonecompany, a toll road, or a port. It becomes veryimportant in situations in which an independentpower producer has to supply electric power toa monopoly buyer, such as a public sector dis-tributor, or a water purifying company has tosupply water to a municipal distributor. Becausethe Þnancial condition of public sector utilitiesin developing countries is often very weak,investors are naturally concerned about the riskof nonpayment for power or water delivered tothe distributor when the producer has no alter-native outlet for the product.

The long-term solution to this problem is toimprove the Þnancial standing and creditwor-thiness of the utilities or to privatize distributionso that private sector suppliers can deal directlywith private distribution companies or under-take distribution themselves. Pending suchimprovement a variety of alternatives exist.Independent power producers in India havetypically sought state government guarantees ofpayment for power delivered and creditenhancement through a counterguarantee of thestate governmentsÕ obligations by the centralgovernment. Alternatively, they have sought toset up escrow arrangements under which pay-ments due to the utility company from high-quality industrial consumers are placed inescrow accounts for settlement of the dues of theprivate power producers as a Þrst charge.


Regulatory risk. Regulatory risk arisesbecause infrastructure projects have to interfacewith various regulatory authorities throughoutthe life of the project, making them especiallyvulnerable to regulatory action. Tariff formulasensuring remunerative pricing at the start of theproject can be negated by regulatory authoritieson the grounds that the tariff was too high, ashappened in the Bangkok Second Expresswayand the recent privatization of the water supplyin Manila. Problems can arise from the environ-mental sensitivity of many infrastructure pro-jects. Extensive environmental clearances areusually necessary at the start of the project, butclearances can be challenged in public interestlitigation or through direct activism by non-governmental organizations (NGOs), which canlead to delays in construction or disruption inoperation. The experience of the Dabhol PowerProject in the Indian State of Maharashtra exem-pliÞes this problem (see box 6.1). Another sourceof regulatory risk is that environmental concernsand standards can become more stringent dur-ing the life of the project, adding to the costs ofoperation. Private investors will expect explicitassurances that cost increases imposed becauseof regulatory action will be reßected in a corre-sponding adjustment in the tariff to project prof-itability.

In general, regulatory risk is best handled byestablishing strong and independent regulatoryauthorities that operate with maximum trans-parency of procedures within a legal frameworkthat provides investors with credible recourseagainst arbitrary action. This is not simply a mat-ter of setting up new systems and procedures.The systems must be perceived as credible, some-thing that will happen only when sufÞcient expe-rience is gained about their functioning. Untilthen risk perception will remain signiÞcant.

Political risk. Infrastructure projects have highvisibility, and there is always a strong element ofpublic interest. This makes them vulnerable topolitical action that can interrupt or upset settledcommercial terms; in extreme cases it can evenlead to cancellation of licenses or nationalization.These risks can be partially mitigated throughpolitical risk insurance offered by multilateralorganizations, such as the Multilateral Invest-

ment Guarantee Agency (MIGA), or bilateralinvestment protection agreements. They can alsobe addressed by building into the project agree-ment appropriate levels of compensation forarbitrary action, subject to international arbitra-tion. The World BankÕs new partial risk guaran-tee instrument, which covers debt servicepayments in case they are interrupted because ofnonperformance of speciÞc government obliga-tions, is another instrument that can play a use-ful role in this context.

The risks enumerated above are not equallyimportant in all projects, the signiÞcance of par-ticular risks will differ from project to project,depending upon sector characteristics. Roadprojects may have high construction risks, lowoperating risks, and high market risks.Telecommunication projects may have low con-struction risks but high market risks. Power pro-jects with suitable offtake guarantees may havehigh construction risks, relatively low opera-tional and market risks, and high payment risk.Each project has its own risk proÞle, and riskmitigation structures will vary depending on thespeciÞc circumstances of each project.

Because of the nature of the risks and theinvolvement of many participants, includingproject sponsors, lenders, government agencies,and regulatory authorities, risk mitigationarrangements are usually complex. Theyinvolve detailed legal and contractual agree-ments that specify the obligations of differentparticipants and set forth clear penalties for non-performance and protection to investors againstactions beyond their control. The complexity ofthese arrangements often delays implementa-tion. Because public sector infrastructure pro-jects do not use such arrangements, host countrygovernments are often unfamiliar with them.For example, public sector power generatingcompanies that purchase fuel from other publicsector companies typically do not insist on fuelsupply agreements with strict penalty clauses ofthe type demanded by the private sector. Nor dothey insist on power purchase agreements withas much protection in terms of guaranteed com-mitments to purchase power, incentive pay-ments, and penalties. More generally, publicsector interactions for contractual obligationsare often loosely deÞned, with a great deal left to


trust rather than laid down in tightly deÞned,legally binding contracts. Private sectorinvestors cannot be expected to accept thisapproach. Moreover, a much higher level of duediligence is expected from government agenciesin dealing with the private sector.

For all these reasons, the evolution of satis-factory risk mitigation arrangements is difÞcultand time consuming. Lack of experience withsuch arrangementsÑand inadequate apprecia-tion of their necessity on the part of host gov-ernmentsÑcan lead to delays that hold backproject implementation. These problems aremore severe in the early stages and are illus-trated by IndiaÕs experience in trying to attractprivate sector investment in power generation(box 6.1) and telecommunications (box 6.2).

Costs of risk mitigation

Risk mitigation involves costs, which raises thequestion of whether private sector projects,which require risk mitigation, are unnecessarilycostly compared with public sector projects. Theanswer depends on whether the risks involvedrepresent real potential costs that have to beborne even if the project is undertaken by thepublic sector and whether the premium paid forrisk mitigation is too high.

Many of the risks that concern private sectorinvestors represent contingencies that shouldconcern public sector projects as well. For exam-ple, the risk of a fuel supply interruption is justas great in a public sector project, and the result-ing loss of power generation represents a realcost to the project and the economy. Public sec-tor power producers are less concerned withprotecting themselves against these risks, partlybecause they are less concerned with ensuringthe commercial proÞtability of each project andpartly because they perceive that shifting theserisks to other parts of the public sector would notimprove the system as a whole.5 Risk mitigationin these cases raises the explicit cost of privatesector projects, but it does not necessarily makethem more costly for the economy as a wholesince the same costs are incurred in public sectorprojects, whether or not they are made explicit.Explicit assignment of risk to agents better ableto manage them could reduce costs if it leads to

improved management of risk.In some situations, however, private sector

projects face risks that do not arise in the case ofpublic sector projects. For example, privateinvestors may be concerned about risks stem-ming from lack of clarity of government policy,the absence of a credible regulatory system, andthe possibility of arbitrary political action. Highrisk perception on these counts leads to high pri-vate sector project costs, because many investorsare discouraged from exploring investment pos-sibilities, leaving the Þeld to investors willing tolive with greater uncertainty in the expectationof higher returns. These high returns are ulti-mately paid for by the consumer in the form ofhigher tariffs (or where tariffs are Þxed inde-pendently, lower license fees accruing to theexchequer). It should be noted, however, thathigher costs in these situations are not caused byrisk mitigation but arise precisely because riskscannot be mitigated and are traded off againsthigh returns. The aim of policy in such situationsshould be to reduce perceived risks by intro-ducing greater clarity in government policy andproviding an environment that reassuresinvestors. Such an environment, which shouldinclude a legal framework for enforcing con-tractual agreements and independent regula-tory authorities to ensure fair treatment, wouldencourage a larger number of private investorsto enter the Þeld. The resulting increase in com-petition could be expected to reduce the cost atwhich services are offered.

Sources and methods of Þnancing

Once suitable tariff Þxing mechanisms and riskmitigation structures are in place, private sectorprojects become Þnanceable in principle. At thisstage project implementation depends on theability to develop a Þnancing package with amix of Þnance suitable for the project. This mixvaries from sector to sector. Telecommunicationsprojects, which face relatively high market risks,may require a relatively low debt component,with debt to equity ratios close to 1:1. Power pro-jects with assured power purchase arrange-ments may be Þnanceable with debt to equityratios of 2.5:1 or even 3:1. The maturity require-ments of debt will also vary across sectors.


Power and roads, which have longer payoffperiods, typically require long maturities, whiletelecommunications projects can manage withshorter maturities. The mix between domesticand external Þnancing also requires careful con-sideration. Even if external Þnancing is availablefor well-managed developing countries, foreignexchange risk management considerations mayargue in favor of keeping the amount of foreignÞnancing within reasonable limits.

There are limitations and constraints associ-ated with each source of debt and equity Þnanc-ing (table 6.1), which should be kept in mindwhen devising Þnancing packages for individ-ual projects.

Equity Þnancing

Private sector infrastructure projects requiresubstantial equity Þnancing, with higher equityrequirements required for projects with higherlevels of perceived risk. Project sponsors are animportant source of equity, but they contributeonly part of the total equity in most cases.Although preconstruction, or developmental,costs represent only a small fraction of total costin infrastructure projects they can neverthelessrun into several millions of dollars, all of whichmust be Þnanced by equity provided by projectsponsors.6 Once the developmental phase endsequity must be committed as part of the Þnanc-ing package. Sponsors typically commit a sub-stantial proportion of total equity themselves,and they also tie up additional equity from otherinvestors at this stage. Foreign sponsors mayoften be keen to link up with domestic investors

India’s telephone services were run as a public sector monop-oly until 1992, when private sector cellular services wereallowed to operate in four metropolitan cities (Delhi, Bombay,Calcutta, and Madras). Shortly thereafter both cellular and basicservices were opened up for private sector operators in twentytelecommunications circles covering the entire country.Although at each stage private sector operators were chosenthrough a form of competitive bidding, the process was criti-cized and challenged in court.

Introduction of cellular services in the four cities was doneby soliciting bids from companies shortlisted on the basis ofqualifying criteria. Call charges were independently fixed, andpotential entrants were asked to bid in terms of criteria such asthe rental charge on the phone, the extent of domestic equip-ment purchase, and projections of investment and perfor-mance. The weights assigned to each criterion for bidevaluation were not made public. The initial selection oflicenses on this basis was challenged in court, and a fresh selec-tion had to be made at the direction of the court.

The bidding process was much more transparent for theextension of cellular and fixed phone services throughout therest of the country. Eligibility criteria were made public, and bidswere solicited for individual circles on the basis of the licensefee offered and three other quantifiable criteria. Weightsassigned to each criterion were also made public. Potential bid-ders were even asked to seek clarifications, and all clarificationsissued were made public before the final submission of bids.Despite these efforts at transparency, problems persisted:

• Although bidders were given the opportunity to seekclarifications, key issues remained unclear. For exam-ple, although bidders had assumed that the licensefee would be treated as a current expenditure for

purposes of computing taxable income, theDepartment of Revenue took the view that underIndian Tax Law it would have to be treated as a cap-ital expenditure. It has subsequently been clarifiedthat the license fee will be treated as a capital expen-diture, with full amortization within the licenseperiod.

• Winning bidders ran into difficulties in reaching finan-cial closure, because it was not clear whether thelicenses could be assigned to lenders in the event ofa debt service default. Lenders took the view thatwithout assignability the projects could not befinanced. It was subsequently agreed that theselicenses could be assigned.

• Disputes arose over the interconnection chargeslevied on the new operators for connecting with theexisting public sector system. The tender documentshad not specified the interconnection charges, indi-cating only that they would be based on costs. In theevent, private operators claimed that the chargeswere much higher than justified, and the chargeswere subsequently reduced through consultation.

• The absence of a telecommunications regulatoryauthority meant that negotiations on points of disputewere conducted between new private operators andthe Department of Telecommunications, which isalso responsible for operating the public sector tele-phone system. This led to complaints from privatesector operators of lack of transparency and fairness.A statutory regulatory authority has since been estab-lished.

Box 6.2 Competitive bidding in telecommunications services in India


at this stage on the grounds that this will reducepolitical risk. Domestic investors tend to evalu-ate risk less conservatively than foreigninvestors, and their involvement often helps toimprove the perceptions of foreign investors.

Well-structured projects can expect to mobi-lize equity from international infrastructurefunds specializing in investment in infrastruc-ture projects. The Global Power Fund, which hasa target of $1 billion, is an example of an infra-structure fund aimed at Þnancing power pro-jects in emerging markets. The AIG AsianInfrastructure Fund, which will invest $1 billionin the Asia-PaciÞc region, and the $750 millionAsian Infrastructure Fund are examples ofregional funds. The amounts available throughthese funds remain modest relative to the totalrequirement, but the pool of global capital theycan tap is very large, and the ßow of equity fromthis source could increase substantially if bank-able projects become available and the trackrecord of implementation improves. An impor-tant aspect of these funds is that they allow inter-national investors to pool risks by investing in amix of projects. They also enable institutionalinvestors, who are relatively risk averse, toinvest in infrastructure projects after the con-struction stage, when project risks are muchlower. This provides valuable opportunities forÒtake-outÓ Þnancing, enabling projects to beÞnanced through the earlier and riskier stage bymuch larger involvement of equity from thesponsors or by high-cost debt, with a subsequentrestructuring through attraction of equity frominfrastructure funds through sale of sponsorsÕequity or reÞnancing of debt with equity.

A limited amount of equity support for pri-vate sector infrastructure is also available frommultilateral organizations, such as theInternational Finance Corporation and the pri-vate sector window of the Asian DevelopmentBank. Although these funds can provide only asmall amount of capital, their participation in aproject provides comfort to other investors.

The scope for raising equity from domesticcapital markets is probably limited. Public utili-ties and domestic institutional investors may bewilling to contribute part of the equity for projectexpansion, but signiÞcant domestic equity sup-port may not be forthcoming for new infrastruc-

ture projects until there is a track record of per-formance. However, once project implementa-tion proceeds and revenues begin to begenerated through partial commissioning, itmay be possible to tap a wider range of equityinvestors. This can be a useful Þnancing strategyin the case of power projects with more than onegenerating unit or in telecommunications pro-jects, where the build up of line capacity occursover time.

External debt Þnancing

Several sources of external debt Þnancing areavailable to well-structured private sector pro-jects in countries with reasonable credit ratings.

Export credit agencies. Export Credit Agencies(ECAs), which provide direct Þnance and guar-antee commercial bank credit, have been thedominant source of international capital toÞnance infrastructure projects. In recent yearsECAs have tended to guarantee bank loans.Traditionally, they funded public sector projectsbacked by sovereign guarantees, with somewillingness in recent years to lend against guar-antees of commercial banks. Unless ECAs canreorient themselves to provide Þnancing with-out sovereign guarantees, their role in Þnancingprivate sector infrastructure projects is likely tobe limited.

International commercial banks. Internationalcommercial banks are the largest source of pri-vate Þnance for infrastructure development indeveloping countries. Of the $22.3 billion raisedby developing countries for infrastructureÞnancing in 1995, syndicated loans accountedfor $13.5 billion, bonds for $5.3 billion, andequity for about $3.5 billion (International Bankfor Reconstruction and Development 1997).Banks tend to be Òhands onÓ Þnanciers, lendingon the basis of a detailed analysis of project risk.

There are important limits to bank Þnancing,however. The number of international banksactively involved in developing countries is lim-ited, and they are subject to exposure limits forprojects and countries. This often leads to syn-dication, which involves cumbersome proce-dures. Another important limitation of


commercial bank lending is the mismatchbetween the Þfteen- to twenty-year loansneeded by infrastructure projects and the seven-to ten-year maturities sought by internationalbanks. Maturities of commercial bank loans canbe lengthened ab initio through multilateralguarantee support for later period repayments,as discussed later in this section. Reliance onbank Þnancing for infrastructure projects musttherefore be part of a mix involving other long-term lending, or it must be accompanied by suit-able reÞnancing arrangements.

International bond markets. Bond Þnancing isin many ways the ideal source of Þnance forinfrastructure. Costs are higher than for syndi-cated loans, but maturities of ten to thirty yearsare typical, and even longer maturities are avail-able for creditworthy issuers. Bond Þnancinghas been the fastest growing source of Þnancefor developing countries in recent years, withtotal ßows increasing from $2.3 billion in 1993 to$45.8 billion in 1996 (International Bank forReconstruction and Development 1997). Its roleremains modest, however, with only $5.3 billionprovided in 1995 compared with $13.5 billionfrom syndicated loans.

One reason for the modest scale of bondÞnancing of infrastructure is that access to inter-national bond markets is not easy. Rule 144Aand Regulation S of the U.S. Securities andExchange Commission allows non-U.S. compa-nies to raise capital in the United States fromqualiÞed institutional buyers without comply-ing with the full listing procedures or conform-

ing to Generally Accepted Accounting Practices(GAAP). However, this window can be effec-tively tapped only by corporate bodies with rel-atively high credit ratings. Newly establishedinfrastructure companies may Þnd it difÞcult toaccess bond markets. Despite these limitationsbond markets are likely to become increasinglyimportant over time as more and more privatesector infrastructure projects are successfullyimplemented in developing countries, compa-nies engaged in such projects gain Þnancialrecognition, and countries develop track recordsof successful implementation. Even new infra-structure companies may be able to access bondmarkets in the postconstruction stage, when riskperceptions have diminished and projects beginto generate steady revenue streams. BondÞnancing could be used in this way to reÞnanceshorter-term loans taken initially to Þnance theconstruction stage.

The pricing of private corporate securitiesissued in international bond markets dependspartly on corporate Þnancial characteristics andpartly on country characteristics. The efÞciencyof bond pricing can be enhanced by the existenceof sovereign debt actively traded in the market.This increases country visibility, and thereforethe appetite for corporate securities, and alsoprovides a benchmark against which corporatedebt can be efÞciently priced. Issuing sovereigndebt, however, implies that countries must bewilling to accept continuous scrutiny of macro-economic performance and economic policiesby international credit rating agencies.

Table 6.1 Financing sources for private sector infrastructure

Domestic sources External sources

EquityDomestic developers (independently or in collaboration with

international developers)Public utilities (taking minority holdings)Other institutional investors (likely to be very limited)

DebtDomestic commercial banks (3-5 years)Domestic term lending institutions (7-10 years)Domestic bond markets (7-10 years)Specialized infrastructure financing institutions

International developers (independently or in collaboration withdomestic developers)

Equipment suppliers (in collaboration with domestic or internationaldevelopers)

Dedicated infrastructure fundsOther international equity investorsMultilateral agencies (International Finance Corporation, Asian

Development Bank)

International commercial banks (7-10 years)Export credit agencies (7-10 years)International bond markets (10-30 years)Multilateral agencies (15-20 years)Bilateral aid agencies


Multilateral institutions. Multilateral institu-tions, such as the World Bank and the AsianDevelopment Bank, which have traditionallyfunded public sector infrastructure projects, arenow willing to support private sector projects.The role of these agencies is necessarily limited,however. There are many competing claims ontheir scarce resources, and diversion ofresources to fund private sector projects mayrepresent no net gain for the economy. It can beargued, however, that these agencies can play animportant catalytic role in the early stages ofattracting the private sector into infrastructure.The transparency of their project evaluation pro-cedures and their ability to benchmark an indi-vidual private sector project in a particularcountry against international experience of sim-ilar projects could help avoid controversies thatmay otherwise arise about private sector pro-jects. Their active involvement as lenders in aproject can also help reduce risk perception onthe part of other investors. However, the proce-dures of these institutions are often too cumber-some to be acceptable to private sector investors.

The International Finance Corporation (IFC),the private sector arm of the World Bank Group,could play an important role in Þnancing privatesector infrastructure, but its scale of operationsis relatively modest. IFCÕs own commitments forinfrastructure projects have increased from a lit-tle less than $200 million in 1990 to $727 millionin 1996, and IFC syndication provided an addi-tional $700 million in 1996. An important featureof IFC syndication in Þnancing private sectorinfrastructure is that it has brought in nonbankÞnancial institutions, including internationalinsurance companies, to Þnance infrastructureprojects in developing countries. A strong casecan be made for much more extensive IFCinvolvement in Þnancing private sector infra-structure projects in developing countries.

An innovative role played by multilateralinstitutions is the use of their guaranteeingcapacity to extend the maturities of commercialloans to private sector infrastructure projects.The World BankÕs partial credit guarantee is anexample of such assistance. It was used to guar-antee principal repayment from year 11 to year15 for a $150 million commercial bank loan forthe Zhejiang project in China. Since China had

access to commercial loans of only about six-year maturities at the time, the partial creditguarantee helped to extend even the uncoveredperiod of commercial lending beyond the nor-mal six-year period to ten years, after which theguarantee period extended it further to Þfteenyears. In the Philippines the partial credit guar-antee has been used to support a $100 millionten-year bond issue by the National PowerCorporation in the form of a put option thatenables the investors to present the bonds to theWorld Bank for principal repayment at maturity.The Asian Development Bank has also providedloan guarantees.

Bilateral aid agencies. Bilateral aid agencieshave traditionally funded public sector infra-structure projects, but their role in funding pri-vate sector projects is likely to be very limited.Their resources are severely limited, and theirpriorities are shifting to social sector projects,making them reluctant to Þnance projects thatare commercially Þnanceable. However, likemultilateral agencies, bilateral agencies couldplay an important catalytic role in the earlystages of promoting private sector investment ininfrastructure, especially by coÞnancing privatesector projects with multilateral agencies.

Domestic debt Þnancing

Unlike the supply of external debt, which isplentiful, the supply of domestic debt is severelylimited in most developing countries. Analysisof 140 private sector infrastructure projects fromIFCÕs portfolio shows that only a sixth of debtÞnancing (which represented 61 percent of totalproject cost) was domestic debt (InternationalFinance Corporation 1996). Moreover, all of thedomestic debt was from local commercial banks,which do not provide long-term Þnance. This isclearly not a viable Þnancing pattern. If privatesector investment in infrastructure is to increasesubstantially, more domestic debt must besecured, and the composition of this debt mustshift to longer maturities. This can happen onlyif domestic debt markets in developing coun-tries develop.

Development of domestic debt markets


Domestic debt markets in developing countriesare underdeveloped for many reasons, andaction to develop these markets has to be takenon several fronts. A high rate of domestic sav-ings is the most important structural prerequi-site for ensuring an adequate ßow of domesticÞnance for private infrastructure. High savingsrates are not enough, however. Most East Asianeconomies, for example, have very high rates ofsavings, and yet debt markets in theseeconomies are underdeveloped, with long-termdebt particularly scarce.

A critical requirement for well-functioningdebt markets is a sound macroeconomic bal-ance, as reßected in modest Þscal deÞcits. HighÞscal deÞcits have signiÞcant negative effects. Ifmonetized they lead to inßation, which discour-ages savings in general and long-term saving inparticular. If not monetized they put pressure oninterest rates, which discourages investment,especially in projects with long gestation peri-ods, such as infrastructure. High interest ratesalso tempt governments to intervene in Þnancialmarkets to reduce the cost of government bor-rowing by forcing banks, insurance companies,provident funds, and pension funds to invest ahigh proportion of their assets in governmentsecurities. This reduces the cost of governmentborrowing, but it obviously does not eliminatethe crowding out effect of high levels of govern-ment borrowing for nongovernment borrowers.In fact, the artiÞcial lowering of interest rates ongovernment securities distorts the governmentdebt market, discouraging active trading in gov-ernment securities and preventing the emer-gence of a reliable yield curve, all of which workagainst the development of an efÞcient debtmarket. Effective control over Þscal deÞcits istherefore an important element in any strategyfor developing debt markets.

Another factor that helps to develop deepand liquid domestic debt markets is the exis-tence of strong long-term contractual savingsinstitutions, such as insurance companies andpension funds. These institutions have long-term liabilities and therefore have a naturalinterest in long-term debt instruments of highquality. Unfortunately, the insurance and pen-sion funds sector is in only an early stage ofdevelopment in most developing countries.

Statutory pre-emption of resources is high inmany countries. In India insurance is also a pub-lic sector monopoly, although the governmenthas recognized that reform of the insurance sec-tor is linked to Þnancing of infrastructure andhas initiated a process of reform in this sector. Anideal environment for domestic debt markets isone in which domestic savings rates are high, Þs-cal deÞcits are low, and there is a strong insur-ance-pension fund segment in the Þnancialsector.

Tax incentives for infrastructure Þnancing.Faced with weak debt markets many develop-ing countries have sought to use tax incentivesto stimulate a larger ßow of domestic savings toinfrastructure development. A wide variety ofincentives are in use in many countries:

¥ The most popular incentive, available inChina, India, and Thailand, is a tax holidayfor the proÞts of private sector infrastructureprojects. This instrument is not aimed specif-ically at domestic debt Þnancing. However, itimproves project proÞtability and thusenables the project to compete more effec-tively with other claimants for scarce domes-tic debt. The additional cash ßow alsoenables the project to sustain larger debt ser-vice payments, thus enabling it to managewith shorter maturities, an important advan-tage where long-term debt is scarce.

¥ Incentives can also be directed at individualholders of equity or debt. In India, for exam-ple, long-term savings by individuals in theform of premia for life insurance policies orcontributions to the Provident Fund beneÞtfrom a tax credit. This incentive has beenextended to investments in the shares orbonds of infrastructure projects. In a similarvein, capital gains on sale of shares have beenexempted from taxation if the proceeds areinvested in equity or debt instruments issuedby infrastructure projects. These incentivesdo not distinguish between equity and debt,but they will help to attract debt Þnancinginto infrastructure.

¥ Tax incentives can also be aimed at Þnancialintermediaries. Financial institutions in Indiaare encouraged to provide long-term Þnancefor infrastructure by allowing 40 percent of


the proÞt attributable to such loans to bededucted from income in computing taxableincome. Tax incentives are criticized by purists on the

grounds that they are indirect subsidies, whichare usually not justiÞable. But a good case can bemade for such incentives, at least in the earlystages of attracting private investment. The con-cern that tax incentives may lead to excessivelyhigh rates of return is fully met by ensuring aprocess of competition in Þxing tariffs or licensefees. Within such a framework tax incentivesessentially allow private investors to provideservices at lower cost to the consumer thanwould otherwise be possible. Since public sectorsuppliers beneÞt from various hidden subsidies(such as low-cost loans from the budget or pro-vision of government equity on which a com-mercial rate of return is rarely earned or evenplanned for), the tax incentive serves only tolevel the playing Þeld.

Innovative instruments with which to promotedebt Þnancing. Innovative Þnancing instruments,such as the use of mezzanine debt, can some-times attract domestic Þnancing to infrastruc-ture projects. Mezzanine debt refers to hybridinstruments that are somewhere between debtand equity (subordinated to secured debt butsenior to equity in the hierarchy of creditors). Avariety of such instruments, including simplesubordinated debt, convertible debt, debt withstock warrants, and debt with an additionalinterest payment above the coupon rate contin-gent upon Þnancial performance, exists. Theseinstruments appeal to investors looking forhigher returns than secured debt provides or fora share in the Òup sideÓ risk of the project.Introduction of mezzanine debt in projectÞnancing for a given level of equity helps toimprove the quality of senior debt and thereforeits marketability.

There are several examples of the use of mez-zanine debt in infrastructure Þnancing in Asia.The Zhuhai Highway Company Ltd. raised $200million in international capital markets, consist-ing of $85 million in senior notes and $115 mil-lion in subordinated notes. The Manila Skywayproject relied on a combination of senior debtand mezzanine capital. The demand for mezza-

nine debt is also reßected in the emergence ofdedicated mezzanine debt funds, such as theAsian Infrastructure Mezzanine Capital Fund,sponsored by the Prudential Capital InsuranceCompany. The ability to adopt a mixed strategyof relying on a combination of higher-cost mez-zanine debt and lower-cost senior debt widensthe pool of investors that can be tapped and canlower the overall Þnancing cost of the project

The role of specialized Þnancial institutions.Many countries have sought to address deÞ-ciencies in their domestic debt markets by creat-ing specialized institutions to deal withinfrastructure Þnancing. Examples of such insti-tutions are the Pakistan Private Sector EnergyDevelopment Fund, established in 1988, whichprovides subordinated loans to private sectorpower projects, and the Jamaica Private SectorEnergy Fund, established in 1992, which was setup to provide long-term Þnance. In India theInfrastructure Development Finance Companywas recently set up as a private company, inwhich the government has a minority stake,with the objective of playing a catalytic role inchanneling resources into commercially viableinfrastructure projects (see box 6.3). A similarinstitution is being set up in Colombia.

Skepticism is sometimes expressed aboutwhether creation of a specialized institution willimprove Þnancial intermediation. A new insti-tution adds little if it only redirects resourcesthat would have ßowed from existing institu-tions to target sectors. Specialized institutionsmay appear to contribute additional resourceßows if they are a conduit for governmentresources earmarked to support private sectorinfrastructure or if they are able to use govern-ment guarantees to obtain funds from the mar-ket at lower rates. However, the same subsidiescould be extended just as effectively by channel-ing this support through existing Þnancial insti-tutions. It can be argued that because of theirspecial mandate specialized institutions willensure a larger ßow of funds to target sectors. Ifmore Þnancing ßows to target sectors becausethese institutions are better able to Þnd bankableinfrastructure projects, then these institutionsare providing valuable Þnancial intermediation.If, however, more funds ßow to target sectors


because these institutions simply apply lowerstandards of credit appraisal in order to achievesome externally set target, the institutions mayend up Þnancing infrastructure projects thatother Þnancial institutions regard as unÞnance-able on conventional criteria, and they will notbe contributing to the efÞciency of the Þnancialmarkets.

The case for establishing a new institutiontherefore depends on whether it Þlls some criti-cal gap in the Þnancial environment facing infra-structure projects. Several such gaps justifycreating a specialized Þnancing institution:

¥ Identifying Þnanceable projects: SpecializedÞnancing institutions may be able to identifyÞnanceable infrastructure projects moreeffectively and proactively than multipur-pose Þnancing institutions. Moreover, theymay be able to help structure projects in amanner that makes them Þnanceable, takingcare to meet the complex risk mitigationrequirements of different types of investors.

¥ Take-out Þnancing: Infrastructure projectsmay need Þnancing arrangements in whichthe project can be Þnanced initially on thebasis of shorter-term debt (such as creditfrom suppliers to Þnance equipment pur-chase) that is reÞnanced later by longer-termdebt. A specialized institution could helpguarantee such reÞnancing within a prede-termined Þnancing cost. This amounts to giv-ing the project an assurance that ifreÞnancing is not available on speciÞedterms when needed, it will either be pro-vided directly by the institution or the differ-ence between the predetermined cost ofÞnancing and the cost at which funds can be

raised will be reimbursed to the project. Acommercial fee should, of course, be chargedfor this service.

¥ Liquidity support: Bond issuance by infra-structure projects can be encouraged by pro-viding liquidity support for such bonds inthe form of a put option prior to maturity orin the form of market making.

¥ Securitization: A specialized Þnancing insti-tution could securitize the cash ßow fromloans in a pool of successfully operatinginfrastructure projects, thus helping to createa wider market for such assets. Pooling ofassets would help reduce risk through diver-siÞcation and thus create a high-quality assetthat could be effectively marketed to bothdomestic and international institutionalinvestors.

¥ Direct Þnancing: Conventional direct Þnancingof infrastructure projects on a limited scale by aspecialized institution may give conÞdence toother investors, which could leverage largerßows from other sources. This is especially true ifthe institution aims to Þll critical Þnancing gaps.The provision of subordinated loans, for exam-ple, helps to improve the quality of senior debtand may stimulate a larger ßow of total resourcesat lower cost than would otherwise be possible.

A specialized institution can also play a veryuseful role as an interface between the govern-ment and new private investors in infrastruc-ture. Many practical problems are likely to arisein the course of implementing private sectorprojects that may require constant review andmodiÞcation of announced policies and also ofthe regulatory framework. A specialized Þnanc-ing institution with direct involvement in indi-

The Infrastructure Development Finance Company (IDFC)was incorporated in January 1997, with 40 percent of theequity held by the government of India and the Indian ReserveBank and 60 percent held by nongovernment domestic finan-cial institutions, foreign investors, and multilateral agencies.IDFC will operate on a commercial basis to finance viable pro-jects in power, telecommunications, roads, ports, and urbanservices. It will not compete with existing financial institutionsas a direct lender but will engage in innovative financing to sup-port other institutions raise funds for infrastructure or providesupport for infrastructure projects in critical areas.

IDFC will provide direct lending, purchase of loans, andcofinancing; take-out financing, standby finance, and refinanc-ing of longer maturities; partial credit guarantees and otherforms of credit enhancement for infrastructure projects; secu-ritization of infrastructure loans and market making for theseloans; and mezzanine finance.

The initial capitalization, including Tier-II capital, is $530million. IDFC’s capitalization and commercial practices willenable it to achieve a high credit rating. It will also be able tobenefit from credit enhancement through credit risk guaranteesprovided by multilateral development banks.

Box 6.3 India’s infrastructure development finance company


fact, it may take several years after a crediblerestructuring process has been initiated beforethese organizations gain full Þnancial credibilityin Þnancial markets. During this period theguarantees of these organizations may not beacceptable, and government guarantees mayhave to be provided as an interim arrangement.Extension of government guarantees in thesecircumstances can be justiÞed, provided the pro-jects meet high standards of viability and themore fundamental corrective steps are under-way. In order to minimize the extent of guaran-tee exposure, the guarantees can be structured toinclude Òfall awayÓ provisions, which are trig-gered as soon as certain credit benchmarks areachieved (Johnson, Mody, and Shanks 1996).

Conclusions

Despite active pursuit of private investment ininfrastructure by most developing countries anda growing number of success stories, the pace ofsuch investment remains slower than initiallyexpected. The main reason is that the precondi-tions for private Þnancing of infrastructure aremore difÞcult to establish than is commonlyrealized. Inadequate preparatory work leads tounanticipated problems and delays in imple-mentating private sector infrastructure projects.

One set of problems arises because infra-structure sectors are invariably subject to tariffregulation and it is difÞcult to strike a balancebetween ensuring that tariffs are sufÞcientlyremunerative to private investors and ensuringthat they are seen as fair to consumers.Consumer acceptance is especially a problemwhere consumers have grown accustomed tounrealistically low tariffs charged by public sec-tor systems, reßecting large explicit or implicitsubsidies. Since similar subsidies cannot beextended to the private sectorÑindeed, theircontinuation even for the public sector may notbe feasibleÑa shift to more viable tariffs isunavoidable. Unless the need for this shift iswidely accepted, it will be difÞcult to attract pri-vate investment in infrastructure.

Even where the need for higher tariffs isaccepted in principle, tariffs charged by privatesector suppliers may still attract criticism if theyare perceived as too high. Economic efÞciency

vidual projects and with knowledge of domesticand international Þnancial markets can help toidentify problems and work cooperatively withgovernment agencies to Þnd solutions consis-tent with the requirements of Þnanceability onthe one hand and public concerns on the other.

The role of government guarantees

A general issue that arises in the context ofÞnancing private sector infrastructure projects isthe role to be played by government guarantees.Private investors seek guarantees to cover a vari-ety of circumstances. However, indiscriminateuse of the governmentÕs guarantee power is notjustiÞable, since it involves a potential cost to theexchequer that becomes a real cost if the guar-antee is invoked. Many projects that face Þnanc-ing problems are denied Þnance because ofgenuine deÞciencies in Þnancial viability. Insuch cases, the deÞciencies must be remedied atthe source rather than being covered by govern-ment guarantees.

In some situations, however, extension ofgovernment guarantees is necessary and appro-priate. The most logical use of government guar-antees is to cover events over which thegovernment has full control, such as national-ization, government action that forces interrup-tion of the project, or nonperformance of speciÞcgovernment obligations. In all these cases exten-sion of government guarantees reduces the per-ception of risk and therefore costs. Governmentguarantees may also be sought to backstopobligations of government-controlled entitieswhere the guarantees of these entities are notcommercially acceptable. For example, privatepower producers selling power to public utili-ties may insist on guarantees from the govern-ment to cover nonpayment for power, or theymay expect the government to backstop guar-antees of public sector fuel suppliers againstdefaults in fuel supply agreements. In both casesgovernment guarantees are insisted on becauseof the lack of Þnancial credibility of the buyingand supplying organizations directly involved.The ideal solution in such cases is to improve theÞnancial viability of these organizations so thattheir own guarantees can be credible. This trans-formation is bound to take time, however. In


requires that private sector projects should rep-resent least-cost options. This objective is difÞ-cult to realize. Cost-based formulas fordetermining tariffs make it difÞcult to ensurethat efÞciency considerations have been fullyobserved: the padding of costs is difÞcult todetect and leads to unduly high tariffs andinßated rates of return. Competitive biddingprojects is the only transparent method ofresolving this problem. It must be recognized,however, that the effectiveness of competitivebidding depends critically on the quality of thebidding process.

Risks associated with infrastructure projectsalso pose special problems in implementation.Many of the risks are common to any commer-cial venture and can be handled in proven ways.But other risks are unique to infrastructure, forexample, those arising from interface with regu-latory authorities and with other government-dominated agencies. These risks can be reducedto acceptable levels through explicit risk sharingarrangements that deÞne compliance obliga-tions of the government and government agen-cies and specify penalties for default. But thesearrangements are complex and are very differ-ent from the normal ones with public sector sup-pliers. Governments are sometimes reluctant toenter into these arrangements and often do notappreciate the need for them from the investorÕspoint of view.

Independent regulatory authorities with aclear mandate to ensure fair treatment for pri-vate sector suppliers help to reduce perceptionsof risk, as does an efÞcient legal system that pro-vides quick redress, especially in matters relat-ing to contract enforcement. Few countries haveall these institutions in place, however, and deÞ-ciencies in this area explain some of the delay inproject implementation.

Financial markets also impose constraints onproject implementation. Once remunerative tar-iff structures and acceptable risk mitigationarrangements are in place, projects have toachieve Þnancial closure. This requires mobiliz-ing an appropriate mix of Þnancing in terms ofequity and debt. Infrastructure projects requirelong debt maturities, reßecting the long paybackperiod. In the absence of long-term debt, theyneed reasonable assurance of reÞnancing or

take-out Þnancing.Availability of domestic Þnance is perhaps

the most serious constraint on infrastructureÞnancing. Infrastructure projects cannot beÞnanced exclusively or even primarily throughexternal capital, if only because tariffs are usu-ally Þxed in domestic currency and a large shareof foreign currency Þnancing implies a corre-spondingly high foreign exchange risk. A sub-stantial share of project costs must therefore bedomestically Þnanced. Domestic debt Þnancingis likely to pose a special problem because mostdeveloping countries do not have well-devel-oped domestic debt markets and long term debtis especially scarce. Measures to develop domes-tic debt markets are therefore crucial to supportprivate sector infrastructure projects.

By contrast, external capital is more plentifulfor well-structured projects in countries per-ceived as investor-friendly and creditworthyÑboth restrictive criteria, but applicable to a largenumber of countries. The pool of internationaldebt and equity captial available for such pro-jects is fairly large and could grow substantiallyas private sector projects are seen to operate suc-cessfully in more and more countries. As withdomestic Þnance, the biggest problem is access-ing long-term debt. International bond marketsare the logical source for such capital, but accessto these markets remains limited, especially fornew companies implementing projects on a non-recourse basis. Credit enhancement throughpartial credit risk guarantees of the type nowbeing offered by multilateral developmentbanks may be helpful in improving access tobond markets.

The development of domestic debt marketsrequires an environment of Þscal prudence withmoderate Þscal deÞcits that do not put pressureon domestic interest rates. It also requires thedevelopment of an efÞcient and liquid marketfor government debt, which provides the foun-dation for developing a broader market for cor-porate debt. And it requires the development ofinstitutions engaged in mobilizing long-termsavings, especially insurance and pensionfunds, which have a natural appetite for high-quality long-term debt.

No country presents an ideal combination ofcircumstances and experience shows that there

are many ways of solving problems that con-strain such investmentÑways that differ fromproject to project and country to country.Financial markets show great scope for innova-tion in tailoring Þnancing solutions to Þnancingneeds. Policies need to be ßexible to allow suchinnovation to ßourish.

The problems discussed here appear formi-dable, and indeed they are. But the upside is thatdespite these problems an increasing number ofprivate sector projects are being implemented inan ever-growing number of countries. Greaterclarity in policy and proactive efforts by gov-ernments to create the conditions necessary toattract private investment in infrastructure willresult in successful implementation of more andmore projects. This favorable experience willimprove expectations among investors andreduce perceptions of risk. That should help toaccelerate a process that is clearly already underway, though still lacking the momentum that isneeded and that is also feasible.

Notes

The author is Finance Secretary of India. The viewsexpressed in this paper are those of the author and notnecessarily reflect the views of the government ofIndia. Acknowledgments are due to Gajendra Haldea,Harinder Kohli, Edwin Lim, Ashoka Mody, and TehKok Peng for helpful comments on an earlier versionof this paper.1. In periods of high inflation even the periodicity ofthe adjustment can become an important factor, sincetoo long a delay may cause signiÞcant erosion in prof-itability.2. New licensees are typically either given monopolyaccess to the market or face only limited competition.In India, for example, the market has been divided intothirteen subdivisions (circles) for telecommunicationslicensing. Bids have been solicited for one additionalsupplier of basic (Þxed telephone) services in each cir-cle to compete with the existing public sector service.Cellular telephones are entirely in the private sector,and bids have been solicited for two competing suppli-ers per circle.

3. In principle it is possible for fully priced private sec-tor supply of services to be cheaper than underpricedpublic sector services because of greater operationalefÞciency. This effect may not offset the effect of hiddensubsidies in all cases, however.4. The Don Muang Tollway in Thailand has sufferedfrom inadequate traffic because the government didnot dismantle the untolled flyovers, which were tohave been torn down as part of the concession agree-ment. Consumer preference for continuing with thetoll-free option proved stronger than expected, becausethe charging segment was not perceived as generatingbeneÞts commensurate with costs.5. The view that shifting risks from one part of the pub-lic sector to another serves no purpose is erroneous.Even within a public sector framework, clear assign-ment of risk to individual public sector entities, withincentives for risk management, would increase theeffort made by individual entities to avoid the contin-gency involved. For example, a fuel supply agreementbetween a public sector supplier of fuel and a publicsector producer of power with penalties for nonperfor-mance is likely to create incentives for the fuel supplierthat will reduce disruptions in fuel supply.6. Risk is also highest at this stage, since there is no cer-tainty that a satisfactorily negotiated project willemerge. Project sponsors typically expect to reap veryhigh returns on this portion of the investment. Thehigh return to sponsors for preconstruction investmentcan be manifested in purchase of part of the sponsorsÕequity at a substantial premium by new investorsbrought in at the time of financial closure. The sameresult is achieved by charging a premium for freshequity by new investors brought in at the stage of pro-ject implementation.

References

International Finance Corporation. 1996. FinancingPrivate Infrastructure. Lessons of Experience SeriesNo. 4.

International Bank for Reconstruction andDevelopment. 1997. Global Development Finance, Vol.1. Washington, D.C.: World Bank.

Johnston, Felton Mac, Ashoka Mody, and RobertShanks. 1996. ÒA House of Cards.Ó Project and TradeFinance (February): 40-42.


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