Explained: Why Infrastructure Industry Suffers From The Problem Of Cost Overruns and Delays
Global experience shows that time and cost over-runs are the norm for infrastructure projects. In fact, the larger the project, the greater the likelihood of cost overrun. Bent Flyvbjerg points to an iron law of mega infrastructure projects (costing over $1 billion) – “over budget, over time, over and over again”. He found that nine out of ten projects suffer from cost over-runs.
His work and of others identify two main causes for project mismanagement which results in time and cost over-runs. One, strategic misrepresentation, arising from “planners and promoters deliberately misrepresenting costs, benefits, and risks in order to increase the likelihood that it is their projects, and not the competition’s, that gain approval and funding”. Two, optimism bias, whereby developers overestimate traffic or revenue projections.
Such cost over-runs are pervasive across the world, including in developing countries. One study of 95 road and rail projects worth $65 bn across China in the 1984-2008 period found that actual construction costs were 30.6% higher than estimated costs in real terms. It estimates the cost over-runs equal approximately a third of China’s USD 28.2 trillion debt pile.
The same holds for India. It is one of the leaders in PPPs, having, by one estimate, mobilized $338 bn for 847 projects in the 2002-14 period. The country has the world’s largest roads PPP program, with more than 560 projects, with a total length of 45000 km, and with over Rs 2 trillion investments. The vast majority of these projects are toll-based, where the developer assumes the traffic risks. An analysis of these projects found pervasive cost-overruns.
Nearly 69 per cent of them are riddled with cost overruns and 89 per cent of them are faced with time delays… The average cost and time overruns have been 16.25 per cent and 41.2 per cent, respectively… Had the projects been developed within the budgeted cost, we would have been able to build 16.25 per cent km of roads more at the same
cost… if there were no delays, we would have been able to add 41.2 per cent km of roads more in the same period… It was seen that 88.1 per cent of PPPs had cost overruns as compared with 54.37 per cent in non-PPP projects. However, a higher proportion of non-PPP projects had time overruns (92.23 per cent) as compared with PPPs (80.95 per cent). While PPPs have a superior track record in managing time overruns because of private-sector efficiency (and probably also because of the inbuilt incentive to complete projects faster), it was not the case as far as cost overruns are concerned. The average percentage cost overruns in a PPP is close to three times that of what was observed in a non-PPP project. These numbers achieve even more significance if we consider that the average project size of a PPP (Rs 382.46 crore) is about a half more than that of a non-PPP project (Rs 253.89 crore).
An analysis of 1,423 ongoing central sector infrastructure projects belonging to 16 Ministries/Departments costing more than Rs 150 crores each with a total sanctioned cost of Rs 18,25,735 crores and with total anticipated cost Rs 21,44,299 crores show significant cost and time-overruns among infrastructure projects in India.
The average age of projects was found to be 6.3 years, with Railways having 10.8 years, whereas, on average, these projects should be completed in 4-5 years. Further, this age corresponds to and expenditure of just 39% of the project cost. At the prevailing disbursement rate, these projects are likely to take over 10 years to be completed.
The cost over-runs at just 39% of expenditure are already close to 18%. The fully realised cost over-runs are likely to be very large by the time the projects are completed. In fact, most cost over-runs are fully exposed only closer to the project completion when the deficits become evident.
In fact, the most salient example of these problems is the large numbers of stalled projects. The total volume of stalled projects tracked by the Centre for Monitoring Indian Economy (CMIE) has been rising for several years and stood at Rs 13 trillion by end-June 2019.
Over a quarter of the private sector, projects had stalled, and the share has been rising unabated for over a decade. Financing constraints are the single biggest reason for the stalling. While this constitutes all types of investments, infrastructure constitutes a significant share of them and would have among the highest stalling rates.
With cost overruns being the norm, the project’s commercial viability becomes questionable. It is only a matter of time before renegotiations become inevitable. Accordingly, global experience from concession contracts in different sectors shows that renegotiations are the norm. An analysis of over 1300 concession contracts in Latin America by economist Luis Guasch over the 1980-2002 period has shown that 68% of them ended up being renegotiated, with the average time to renegotiation being just one year. Further, 78% and 87% respectively of the contracts in transportation and water were renegotiated with the average time being 0.9 and 0.8 years from contracting.
Further, the study finds that renegotiations invariably favour the contractor at the cost of taxpayers and consumers. Concessionaires demand tariff increases, an extension of concession tenure, back-loading or reduction in their investment obligations, and adjustment of periodic fees payable. And they generally succeed with their requests. Such back-door increases in contractual obligations of the government through re-negotiations detract from the sanctity of the original contract and generate moral hazard.
Eduardo Engel, Ronald Fischer, and Alexander Galetovic examined data on Chilean experience with re-negotiations of 50 PPP projects in the 1993-2006 period and find four observable predictions –
“(i) in a competitive market, firms lowball their offers, expecting to break even through renegotiation, (ii) renegotiations compensate lowballing and pay for additional expenditure, (iii) governments use renegotiation to increase spending and shift the burden of payments to future administrations, and (iv) there are significant
renegotiations in the early stages of the contract, e.g. during construction.”
Another study also found renegotiations to be often linked to aggressive bids or strategic bidding. In fact, it finds the moral hazard of renegotiations, the now entrenched belief that renegotiations are inevitable and leads to better terms, encourage aggressive bids. Contractors have realised that once they win the bid, it is possible for them to seek renegotiations and extract very favourable terms.
In India too, the vast majority of national highways and many power purchase agreements, including all the ultra-mega power projects (UMPP), which were allotted through competitive bids have been or are being renegotiated. And in all of them, aggressive bids have been a feature. In case of the UMPP’s bidders even passed over the option of fuel price pass-through and bid aggressively with extremely low tariff offering, the unsustainability of which became apparent very soon. A study of the power generation PPAs in India found that connected firms bid strategically low-balled their bids so as to bag the contract since they could use the inevitable cost-shocks to obtain favourable terms in any renegotiations.
Such renegotiations are commonplace in developed countries too. For example, studies have shown the renegotiation rates in highway projects to be 40% and 50% in the US and France respectively. An NAO study found that 55% of all infrastructure projects in the UK were renegotiated.
While strategic misrepresentation, strategic bidding, optimism bias, obsolescence bargain and so on are contributors to renegotiations, all of them, in turn, find a convenient fig leaf in the information asymmetry arising from deficiencies in the quality of project preparation and contracting. These deficiencies manifest in the form of construction risks, a very ubiquitous but perhaps the biggest challenge with infrastructure projects, one whose effects cascade through the life-cycle of the project.
While improving this cannot eliminate renegotiations, it can significantly lower its likelihood. In fact, several studies, including the Guasch study, have found poor quality of DPRs and contracts to be among the important underlying reasons for contractual problems in PPPs.
The Kelkar Committee Report, too, highlights this.
It is therefore important that the Detailed Project Report (DPR) should be of high quality and one which bridges information asymmetry and makes available as much information as possible to both the government and all the bidders. This allows contractors to bid with greater confidence and thereby enable more efficient price discovery, and in turn, makes the contract less incomplete.
All this should come as no surprise given the deep uncertainties associated with such contracts. It is extremely difficult, even impossible, to conceive of all possible contingencies which can possibly derail a contract over a 20-30 year period. There are too many unknown unknowns to write a reasonably credible contract for such a duration. In any case, renegotiations have become a feature of infrastructure projects across the world. In the circumstances, lowering its likelihood and being prepared for the least distortionary renegotiations may be the best that can be done.
Gulzar Natarajan is an IAS Officer. Views expressed are personal.
This is the fourth article in a multi-part article series on infrastructure financing and the challenges associated with the sector. Read the first part here, second part here, and the third part here.