t6Sl Viewpoint The World Bank Group October 1996 Note No.95 Transaction Costs in Private Infrastructure Projects-Are They Too High? Michael Klein, Although the number of private infrastructure borne by consumers and taxpayers, although Jae So, a nd projects continues to grow, tales of endless de- investors may have to swallow the conse- Ben Shin lays and exorbitant development costs still scare quences of serious miscalculations. The ques- both developers and governments. These costs tion is whether the cost of developing private probably amount on average to some 5 to 10 infrastructure projects undermines their very percent of total project cost-or some US$2 rationale-the cost-effective provision of ser- billion to US$3 billion a year, assuming that vice. To answer this question, this Note assesses investments worldwide exceed US$35 billion the broad magnitude of the costs and the fac- a year. Most of these costs ultimately will be tors driving them. The magnitude of transaction costs fIGURE 1 TRANSACTION COSTS NOT RELATED Developing a private infrastructure project is a TO PROJECT SIZE complex task requiring firms and governments to prepare proposals, market them, conduct Transaction costs bidding or negotiate deals, and arrange fund- (US$ millions) ing. (Box 1 sets out the steps in such transac- 50 tions.) The costs incurred in these processes -transaction costs-include staff costs, financ- 40______ _ ing costs such as placement fees, and advisory fees for investment bankers, lawyers, and con- sultants. Consistent and comparable data on 30 *-- the size of these costs are rare. Prominent de- velopers are unable or unwilling to produce Zf 0 accounts showing detailed transaction costs by project. Nonetheless, it has been possible to ___ _ * * ' Ipiece together a broad picture of these costs by interviewing government officials, financiers, and developers and using data published in 01 , i * i l i the media. 0 1,000 2,00) 3,000 4,000 5,000 Project costs (US$ millionsl The first impression is one of great variation in * Project identification and feasibility studies * Bid evaluation costs across countries, sectors, and time. De- o Bidtendering f Bid award velopers' transaction costs range from a rela- * Bid preparation * Financing arrangement tively small 1 to 2 percent of project costs to well over 10 percent. These estimates exclude Note: Data are fromthirty-three projects but each project does not have a complete te ost of offcist. A ewtlare project set of observations. the cost of officials' hme. A few large projects Source:Datacompiledfromvarioussources(seetextl. have piled up development costs far exceed- ing US$100 million. Some large projects that never made it to closure left developers Private Sector Development Department - Vice Presidency for Finance and Private Sector Development Transaction Costs in Private Infrastructure Projects-Are They Too High? Contract Financing Project ;0X00000'0 Framework $j0ii Feasibility studies '--.Bidding formulation arrangement implementation GOVERNMENT GOVERNMENT GOVERNMENT GOVERNMENT b GOVERNMENT GOVERNMENT * Establish privati- Market Prequalify bidders ii, Financial Consistent Manage and zation agency opportunity Evaluate bids - 'negotiations involvementand adjust regulatory * Pass enabling * Select advisers Award bids Engineering commitment structure to create legislation Conduct economic negotiations Consistent in- stable market * Establish regula- studies Legal negotiations volvement through- conditions tory agency * b Conduct engineer- out financial engi- * Mobilize public ing studies neering process support - Due diligence * Select and identify - Road shows project * Restructure state- owned enterprise DEVELOPER DEVELOPER DEVELOPER DEVELOPER DEVELOPER DEVELOPER * Assess the market ' Conduct economic * Assemble Financial * Financial Operation of busi- b For unsolicited studies consortium negotiations engineering ness bids: * Conduct engineer- Prepare bid Engineering Registration Ensure compli- - Carry out prelimi- ing studies Prepare engineer- negotiations GAAP compliance ance with contrac- 0 nary feasibility * Legal consultation ing proposal Legal negotiations * Auditing tual obligations studies and project Prepare financial Intraconsortium * Underwriting - Ensure compli- identification proposal negotiations Road shows ance with any legal - Identify primary l Intraconsortium Develop financing * Negotiate with i or regulatory decisionmakers in . negotiations plan institutional b changes the government Perform environ- investors - Shepherd project mental assessment Issue shares through the govern- b Work out bid ment award disputes - Project public relations stranded with tens of millions of dollars in ex- Factors driving transaction costs penses. Interestingly, the scatter of observa- tions of selected costs from 33 projects in figure Transaction costs are dominated by staff and 1 shows little relationship between project size travel costs, primarily reflecting the legal and and transaction costs, indicating that the tech- financial complexity of reaching contractual nical characteristics of projects are not the main agreements between numerous parties in es- driver of transaction costs. Industry experts sug- sentially new and unique environments. The gest that transaction costs vary mainly with fa- cost of technical studies appears less impor- miliarity with and the stability of the policy tant than expenses incurred in dealing with gov- environment. Costs are usually about 3 to 5 ernments. Project development time usually is percent in well-developed policy environments, counted in years. Initial optimism about the while they may be 10 to 12 percent in pioneer- speed of progress has often been unfounded, ing projects. and many firms have seen development times BOX 2 A FAMILIAR STORY "Ciudad Progressiva," a municipality in northern Mexico, urgently double. For most projects, development time needsto upgrade its water supply by building a pipelineto a distant falls in the range of two to eight years. river, but is short of money. The mayor knows of private financing possibilities French and British water companies have made numer- Why is the development process so protracted ous tempting presentations. Unwilling to antagonize the and costly? Throughout the process, uncertainty municipalits water company, the mayor decides not to privatize the is typically high. Developers and advisers may be "on hold" for long periods, for example, entirewatersystembutonlVtocontractforthenewpipelinewitha while the government prepares tender docu- private inwestor under a build-operate-transfer concession. ments. When the tender is finally issued, they Themayorsoonlearnsthatthepathtoprivatewaterisanobstacle may have to go on all-night overdrive to com- course. The municipalitys water company, feeling threatened, is plete bids, which suddenly must be submitted slow in providing adequate technical information. Drawing up con- within a matter of weeks. A lack of definition and transparency and a cloak of secrecy over tractsbetweenthemunicipalityandtheprivatecompanyturnsoutto government process can greatly compound un- be complicated, and local procurement practicesimake it difficuftto certainty and with it transaction costs. hire expensive outside counsel. But the mayor somehow manages to hire a competent lawyer, who helps find ways around obstacles aris- These are the symptoms of a simple underlying ing from current regulations and procitrement procedures. After sev- fact: private infrastructure is a new way of do- eral iterations and almost two years, contracts satisfactory to all par- ing business for most governments. Although ties have been drawn up. The private sponsor, dependent on public many private firms are learning as well, gov- emnent is the ultimate decisionmaker in most monopolies for water supply and sales, has insisted on minimum rev- private infrastructure projects, given that these enue guarantees. projects constitute a form of contracting out Discussions with potential lenders, meanwhile, have revealed that complex services. Governments must adjust a credit will not be made availahle unless the municipality obtains a myriad of responsibilities and processes-some- guarantee that it and its water company will have money to meet the times drastically, sometimes just a little. As gov- ernment officials confront the new ways of doing payments when they are duet After a trip to the capital and having ob- business, some feel threatened by the possible tained the governor's approval, the mayor gains assurances that loss of their function and job, some are reluc- Banco Nacional de Obras y Servicios Publicos (BANOBRAS) will is- tant to admit ignorance, and others simply do sue a payment guarantee based on its recourse to future federal tax not see the issues. (For a stylized account of revenues due to the municipality under the revenue sharing system. typical problems based on an actual case, see Lenders now quote their terms. The best offers are seven- to eight- box 2.) Lack of clarity leaves scope for abuse by parties of ill repute, inside and outside gov- year loans carrying interest rates 10 percentage points above the fed- ernment. Allegations of misdeeds become rife, eral governmnent's domestic borrowing rate. often generating a vicious cycle of uncertainty The Ministry of Finance then points out that all the guarantees taken and reluctance to assume responsibility. togethweanount more or less to a sovereign guarantee. In effect, future sovereign revenues are being pledged and a call on them would in- of disarray and the conseqtuent costs of moving crease the public borrowing requiremnent by an equivalent arount- to private provision and financing. But there are everything else being equal And still the banks want a spread of 10 transaction costs in traditional public sector percentage points. "No way,' isthe ministrys response. "So borrow projects too. Private projects simply bring more directly on sovereign guarantee," retort the banks. "But we want it off of the previously hidden costs out into the open. balance sheet,' replies the ministry. "Then pay an extra 10 percent. As Nobody knows exactly how the transaction costs the discussion drags on inconclusively for several months, with the of public and private projects compare. While ministrytrying to squeeze out a lower spread, the mayor's three-year public projects, like private, require intensive and long-drawn-out preparation, private projects tend term ends, and the discussion starts over again from scratch. to involve more scrutiny and negotiation of the Transaction Costs in Private Infrastructure Projects-Are They Too High? details up front and may require mote expensive Equally unbureaucratic solutions are needed advisers. To some extent, this greater attention to allow lessons to flow from one project and to project parameters reflects the shifting of risks sector to others. All too often staff in one agency to private investors, while in public projects many or level of government fail to tap the knowl- risks are silently assumed by consumers and tax- edge of staff in other agencies and unneces- payers. But a tentative comparison of public sec- sarilv start from scratch. One way to improve tor projects funded by the World Bank with the dissemination of lessons is to establish a projects funded by its private sector arm, the In- single private finance entity reporting to the ternational Finance Corporation, suggests that pri- minister of finance. vate projects are more likely to be executed on time and within budget. The "average" public Conclusion sector project suffered time overruns of 50 to 70 percent and cost overruns of 10 to 20 percent in Introducing private participation in infrastruc- dollar terms. Better monitoring in private projects ture seems to increase the transaction costs in may imply higher transaction costs but it also developing projects, although this cost differ- means lower all-in costs. ence may be more apparent than real. Private participation may simply bring otherwise hid- The way forward den public costs into the full light of day. Trans- action costs seem to have more to do with the The Note series is an Some of the higher costs in private projects characteristics of the policv environment than open forum intended to encourage dissemina- are the costs of the transition to a new way of with the characteristics of the project. Thus, tion of and debate on doing business. These costs will fall as gov- they will naturally fall over time, and decline ideas, innovations, and ernments and developers become familiar with more where governments adopt better policy best practices for expanding the private new processes. But decisive government ac- and enforce proper conduct. And the available sector. The views tion on two fronts will reduce costs: evidence suggests that, even with higher trans- published are those of * Clarifying the new responsibilities and rules action costs, private participation means over- the authors and should not be attributed to the of the game in the government. all gains because of the improved incentives World Bank or any of its D Disseminating lessons of experience broadly for efficiency and cost-consciousness. affiliated organizations. within the government. Nor do any of the con- clusions represent Taking all the actions necessary to reduce costs official policV of the Some governments have already clarified re- is tough, though, and many governments will World Bank or of its sponsibilities and rules for government officials continue learning the hard way. But for those Executive Directors t or the countries they through concession laws (Chile, Hungary, and able to undertake thorough reform and to learn represent. the Philippines) or in general government guide- fast, the rewards are large-worldwide, they lines (the United Kingdom and the State of amount to several billion dollars. The Bank's To order additional copies please call the Victoria in Australia). Just as important are build- experience with private power in Pakistan is FPD Note line to leave a ing the necessary institutional capacity for han- indicative of these rewards. The pioneering Hub message (202-458-1111) dling these projects and improving learning from River Power Project took some seven years to or conltact Suzanine Smith, editor, Room experience. As many governments have come reach financial closure. After the policy frame- G8105, The World Bank, to see, hiring experienced advisers is crucial. work was clarified in 1994, the second deal, 1818 H Street, NW, No less crucial is building a competent cadre of for the Uch Power Project, took two to three Washington D.C 20433 officials who understand the intricacies of pri- years to reach financial closure. The next gen- ssmith7@worldbank.org. vate projects and project finance. Because these eration of projects is expected to take only one Previous issues are also skills tend to be scarce and sought after, gov- and a half to two years to reach closure. available on-line lhttp:// i s www.worldbank.org/ ernments may need to adopt unbureaucratic so- html/fpd/notes/ lutions and salary mechanisms to attract and Michael Klein, A/Tanager (mklein@worldbank. notelist.html). retain competent staff. The cost of greater re- org), Jae So, Private Sector Developpment Special- ®Printed on recycled muneration should be offset by the savings from ist (jso@worldbank.org), and Ben Shin, Private paper. the declining need for outside advisers. Sector Developm,ent Departinent