Recent changes to the hybrid annuity model will benefit the road sector.
By Shubham Jain
The central government has set a target of increasing the investment in infrastructure to over Rs 111 lakh crore over the period FY20-FY25, a majority is planned towards transportation, energy, and urban infrastructure. Within the transportation segment, projects worth Rs 36.7 lakh crore, constituting 55% of transportation infra, are for the road sector. The large investments planned in the road sector signifies its importance—it has a multiplier effect on the economy and provides large employment opportunities.
While EPC (Engineering, Procurement and Construction) model involves high financial burden on GoI, of the various development models in vogue—HAM (Hybrid Annuity Model) and BOT (Build, Operate and Transfer)—toll developers prefer the relatively lower risk HAM model. This is due to its various positives like lower equity requirements, provision for mobilisation advances, better right of way availability, inflation-linked adjustments for bid project cost, termination payments during the construction period and de-linking construction and operations. These HAM features have garnered a favourable response and mix of HAM awards has increased from 10% in FY16 to 48% in H1FY2021.
The only major risk for HAM projects, which remained unaddressed until recently, was the prevailing low bank rates adversely affecting the overall project viability and returns. There was a series of downward revisions in the repo rates—the bank rate fell to 4.25% from 6.5-6.75%—at a time many HAM projects were being awarded. During the operations period for a HAM project, the recovery from authority is in the form of fixed annuity payments along with interest on balance accumulated annuity payments (calculated @300 bps over prevailing bank rate).
Overall, such interest receipts account for around 45% of total inflows. RBI bank rates are expected to remain at low levels to revive growth and mitigate the impact of Covid-19 on the economy. Low bank rate would thus reduce the overall inflows for a HAM project, thereby adversely affecting its debt coverage metrics and returns to the investors. The second problem is related to delayed and inadequate interest rate transmission—there is a transmission lag for the project loan (linked to MCLR of banks).
In this context, the recent changes in model concession agreement with a shift to the marginal cost of funds based lending rate (MCLR) from bank rate for computing interest on annuities is a positive development. As per revised concession agreement dated November 10, 2020, interest rate on annuities will be equal to the average MCLR of top 5 scheduled commercial banks plus 1.25% instead of bank rate. With the average MCLR replacing the bank rate, there will be a natural hedge between the annuity inflows and interest costs, thereby reducing the interest rate risks to a large extent, and that too without any delay.
This is a positive move that will protect the returns of the HAM developers and improve its overall attractiveness. The other major revision is the grant payment from the authority which will now be paid in 10 instalments instead of five. Thus, the spacing between the payment milestones is reduced. This will improve the cash conversion cycle for the contractors executing the HAM projects as their payments are back to back in nature. With improved attractiveness, HAM is expected to remain the mainstay for public-private partnership projects in the road sector.
However, these changes will be applicable for new awards, and the fate of the existing HAM projects is hanging in the balance. Change in the applicable interest rate on annuities is critical even for existing projects. This will not only improve the coverage metrics for these projects and, consequently, aid in refinancing but will also help the developers to unlock the capital by selling these assets and redeploy it in new BOT projects, which is the need of the hour.
Around 46 projects (i.e., 33% of total 138 HAM awards) totalling 2,932 km are expected to become operational in next one year; another 24, totalling 1,035 km will be operational in the next 12 to 24 months—these present significant refinancing opportunities. Overall, around 70 projects involving Rs 35,800 crore of debt are expected to become operational in the next two years and are candidates for refinancing through money market issuances where the investors prefer operational assets with steady cashflows.
Senior VP & Group Head, Corporate Ratings, ICRA Ltd. Views are personal