This article first appeared in Forum, The Edge Malaysia Weekly on December 19, 2022 - December 25, 2022

The public-private partnership (PPP) model has been used internationally to finance major infrastructure projects, including highways. However, we argue that the traditional PPP model of build-operate-transfer falls short in the allocation of capital and risks assumed by the private sector/concessionaire, placing a huge burden on the concessionaire, or ultimately the government when the private sector can no longer bear the losses in a distressed project.

This problem is compounded for the concessionaire due to difficulties in raising debt financing from both the commercial banks and the development finance institutions (DFI). Commercial banks are unlikely to fund long-term infrastructure projects without a government guarantee and will find it even more difficult to undertake with the advent of environmental, social and governance (ESG) guidelines. Although DFIs are expected to finance large-scale infrastructure projects to develop and promote economic growth, DFIs have found it increasingly challenging to provide financing after suffering losses lending to previous highways where the actual traffic volumes fell short in comparison with the projections. 

A failed highway initiative, despite clearly demonstrated economic benefits, will have a negative impact on the country’s competitiveness in not serving the intended users and failing to enhance the value of existing infrastructure through the network effect.

In general, risks associated with a highway concession can be split into two phases along the project lifecycle (see chart).

The first major risk is construction risk, which commences from financial close to the date the highway commences operation. The second phase begins when the highway commences, and the risk is now primarily related to revenue generation.

We are confident that the solution lies in risk allocation to parties best suited to undertake and manage these distinct risks. The other important consideration is adopting a flexible financing structure that is matched to the point where revenues can be reasonably assured, and revenue risk is substantially reduced, that is, steady state traffic volumes are achieved.

Our view is that construction risk should remain with the concessionaire as it is best placed to manage and mitigate those risks. The government, with its ability to influence public policies, should undertake the revenue risk as it is better placed to bear this compared to a single concessionaire. 

Highway projects are traditionally funded by a mix of equity and debt (bonds or sukuk). Instead of the promoter issuing an A-rated bond (the best most concessionaires can achieve excluding the well-established names) at financial close, we propose that the government provide the appropriate support in reducing financing cost from the construction phase up to achieving steady state traffic volume. This support could be in the form of a guarantee, which enhances the rating of the bond from A to AAA. 

In exchange for its support, the government is compensated through a fee charge plus an option for an equity stake in the highway concession company. This will afford the concessionaire the best possible financing rates. On the other hand, with the prospect of upside from the equity stake, the government is incentivised financially and aligned with the concessionaire to provide other forms of policy assistance. For instance, a reduction in import tariffs for items necessary to construct and operate the highway. 

The concessionaire must complete the construction on schedule and within budget. No matter the outcome of the construction phase, the government is not disadvantaged, as the provision of the equity option for a fixed percentage of shares to the government is based on the original price, save accepted variation orders. Therefore, the government’s shareholding upon exercising the option is not affected by the demand for additional equity injections by the concessionaire if there are cost overruns or delays. 

This position can be further solidified with a condition that no additional debt must be incurred using the project assets as security or the concession company’s balance sheet. This is similar to standard banking practices when financial support is afforded. There should be no pushback from concessionaires as they are construction companies with the know-how to undertake and manage the construction risks, and any cost overruns are solely due to their failures. 

This structure aligns the interests of the concessionaire and the government, thus creating a true and fair PPP.

If highway traffic volumes are as projected, then the debt is replaced or refinanced by AA-rated sukuk or bond, and the government support is extinguished. This solution enables the government, which is best placed to underwrite revenue risk, to benefit from the upside of traffic volume. Conversely, if traffic volumes fall short of projections, the concessionaire’s loss is limited to its equity and no additional liability would materialise due to the promoter’s financial guarantee, given the credit enhancements provided by the government. In this case, as in any failed major infrastructure project, the government ultimately must step in and resolve the issue. But losses are mitigated by the portfolio effect, which is explained below.

Assuming the government supports multiple projects with the proposed structure, then overall risk is mitigated by having a portfolio of highways where the framework is applied. Some projects may perform better than expected and, in this case, the option will be in the money, which means positive financial benefits for the government. On the other hand, there will be additional cost to be borne by the government to resolve the issues when the project performs below expectations. 

We view this as a positive for the government as at present, the downside is inevitably borne by the government and hence it would not be worse off in entering into the proposed structure of financial support in exchange for fees and an equity option in the concession company. The effect of a portfolio is demonstrated in the table, based on simulations that we had carried out.

Certainly, the government’s participation would not be required if mega global companies or dominant incumbents were involved. However, the downside would be a reduced number of domestic parties that participate in PPPs. Further, technological changes over a period of 20 to 40 years (radical change over the long term) of a concession are not risks we believe the domestic private sector can undertake, as the number of private sector entities of scale in Malaysia that can truly underwrite these projects is limited. Major infrastructure projects provide an opportunity for the implementation of new or disruptive technologies that are normally associated with new players. In this respect, the government should play a critical role in how it can support and facilitate the application of new technologies through the entrance of newer players, even though they are smaller than the incumbents. 

This structure is a catalyst for the development of highways and other major infrastructure projects that need to be carefully considered by policymakers, given the huge upside while mitigating the downside risk and being a critical enabler for the development of the nation. Policymakers must adopt a growth mindset to benefit from the global phenomenon of Rethinking Economics, as the alternative of business as usual would be stagnant productivity, loss of competitiveness and lacklustre growth of the economy. 

Datuk Mohd Anwar Yahya and Ravindran Navaratnam are partners and executive directors at Sage 3, a boutique corporate finance advisory firm that advises major corporations in Malaysia and Singapore

Save by subscribing to us for your print and/or digital copy.

P/S: The Edge is also available on Apple's AppStore and Androids' Google Play.