IIFC invests its time, effort and venture capital at the front end of project development, primarily from Stages 0 to IV. This period of development is the most risky phase for a private sector infrastructure project. IIFC seeks to work on a success fee basis and recovers its development costs from the winning bidder after the completion of Stage IV, i.e., signing of an agreement between the bidder and the Government. The cost of project development is met out of venture capital provided to IIFC. However, for various reasons activities on many projects may have to be terminated at any phase before successful completion of Stage IV. In such cases, IIFC would lose its investment in project development. If the proportion of these unsuccessful projects becomes high, IIFC is exposed to large development risks.1
The risk faced by IIFC arises owing to various reasons, which include:
(a) Project concepts very fluid;
(b) Lack of commitment by the Government;
(c) Lack of knowledge;
(d) Deficiencies or lack of policies;
(e) Vested interests;
(f) Union pressure;
(g) Uncertainty in project design;
(h) Uncertainty in costs;
(i) Uncertainty in viability;
(j) Uncertainty in regulatory regime.
Figure 3 illustrates the risk levels faced by IIFC while it spends funds to develop a project. It also shows the progress in increase of project value and the typical cost profile of IIFC at each of the stage of project implementation. Risk (and cost) begins with Stage 0, when IIFC carries out its business development activities and eventually signs an agreement (DSA) with the concerned ministry or its agency. This is the most risky stage for IIFC as project structure and its viability, government commitment, investors' interest, etc., are all unknown. A DSA establishes government commitment to go forward with the project with private sector financing instead of public sector financing. The DSA reduces IIFC's risk arising from lack of government commitment.
After making a DSA with the Government, IIFC mobilizes consultants to carry out the feasibility study of the project. The consultants for activities in Stage I are easily found, but care is taken to ensure that at least half of them have experience in designated activities in Stages I to V; otherwise, further progress becomes difficult. A feasible project at the end of Stage I validates IIFC's selection of the project and thereby further reduces the risk faced by IIFC. By this time, many of the project details are known and this creates project value, which is typically in excess of the costs to IIFC.2
Figure 3. Risk level and cost of IIFC and project value at different stages of development
In terms of risk involvement, Stage II is the most crucial one for IIFC. This stage also requires highly experienced IIFC staff and consultants to develop the commercial framework for the project. Successful marketing of an infrastructure project depends very heavily on this framework as it considers risk allocation between the Government and the private developer, fiscal and other incentives, form of private participation and its terms, regulatory mechanism, bidding parameters, etc. After developing the model contract agreement and obtaining the Government's approval of it, the next important activity of this stage is the issuance of a request for a proposal (RFP), which indicates the final commitment of the Government to proceed with the project as a private infrastructure project. The chances of a project stalling are highest at this stage. With the successful completion of this stage it is known that credible bidders are willing to invest in the project. As such, considerable reduction in IIFC's risk and increase in project value take place with the end of this stage.
Stage IV involves negotiations with the preferred bidder and ends with the signing of the concession agreement. The signing of the negotiated agreement reflects commitment by the investor and reduces IIFC's risk further. The signed agreement has a good value for the project developer since it gives the developer the right to implement a financially viable infrastructure project and also provides a basis for borrowing money from lenders. With the successful completion of this stage, IIFC's risks as well as role are reduced sharply, as the sponsorship of the project changes hands.
It is evident from the discussions above that IIFC as the inside sponsor enters into the project implementation process much earlier (Stage 0) than the outside sponsor (Stage IV) and the lenders (Stage VI). In terms of project development, IIFC is involved at times when risks are extremely high. Only successful management of the various sources of risks can allow a project to move through the various stages towards its financial closure and from there to construction and commercial operations.
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1 Risk is a perception of difficulties that IIFC may face during various stages of project development, which may cause termination of activities by IIFC at any point before successful completion of Stage IV of a project. Risks may arise owing to technical, financial, commercial, political and regulatory factors. As risk may be considered as the chance that a project successfully completes its Stage IV, the perceived risk of project development decreases as a project progresses over its development stages. However, when the risk of project termination is assessed separately for each individual stage of project development, the risk is highest in Stage II.
2 Project value at any point during project development is defined as the price that a developer would be willing to pay for making an entry into the project at that point. For example, a power purchase agreement (PPA) in India may sell for $ 2-3 million. The project value may not be positive in the initial stages but should become positive over the successive stages of development.