Governments pay when they choose to renegotiate terms

I wrote yesterday about how the Indonesian government were handling a renegotiation of the terms of toll road concession contracts. 

As an example of how this works in countries with more mature regulatory regimes, this article talks about the Victorian government's decision to make trams free in the Melbourne CBD.

The government reported that they did it to help lower the cost of living, and to make it easier for commuters and tourists to use trams in the city. As the operator of the trams would be losing money as a result of this change, the Victorian government had the compensate them for the loss. The cost of the initiative was estimated at around AUD 100 million for the first year of operations.

Reasonable people can differ over whether making trams free is worth the money, or whether AUD 100 million is reasonable compensation for the loss, but the way the Victorian government handled the renegotiation was professional, transparent, and consistent with investor expectations, and good regulatory practice. 

A government like Victoria's knows that it's cheaper to pay AUD 100 million in cash than it is to run the risk of tarnishing their reputation with investors by trying to force the private operator to take the burden of their policy decision. Either way, they'll pay, at least this way they know exactly what it costs them.

All of this contributes to Victoria's perception as a low-risk investment destination, which flows through into cheaper goods and services for Victorian consumers.

Why exactly is Indonesia Air Asia at risk of being shut down?

Reports last week have indicated that AirAsia and 12 other airlines may be forced to shut down their Indonesia operations due to an interpretation of the regulations that says that their license may be revoked if they have negative equity. CNBC quotes Maybank-Kim Eng airline analyst, Mohsin Aziz, as describing it as a "black swan event", further stating the "no country in the world has ever done this."

The airlines affected include: Indonesia Air Asia, Cardig Air, Transwisata Prima Aviation, Eastindo Services, Survai Udara Penas, Air Pasifik Utama, Johnlin Air Transport, Asialink Cargo Airlines, Ersa Eastern Aviation, Tri-MG Intra Airlines, Nusantara Buana Air, Manunggal Air Service, and Batik Air.

The reporting on the matter indicates that the government's concerns with negative equity are safety-related. I don't see the direct link, but perhaps they think that if a company is unprofitable, it may be skimping on safety. Personally, I would rather that the regulator's efforts on enhancing safety are focused on the nuts and bolts, and standard operating procedures of the airlines. Leave the questions of solvency to the airlines' creditors and shareholders.

I'm not that familiar with the aviation law in question. I had quick look through it, but didn't see anything there that specifically dealt with negative equity. It might be some sort of indirect implication that being in negative equity might have. Perhaps something to do with foreign ownership restrictions*, but I'm just speculating here.

Does anyone have any theories as to what article of the law the 13 airlines are supposedly in breach of?


*Any air transportation business must have at least 51% of shares owned by a local shareholder under Indonesia's Negative Investment List.

The Indonesian government just needlessly cost itself and its citizens a hundred million dollars

The Indonesian government announced last week that they will be cutting toll road tariffs by 25% on private toll roads, and 35% on Jasa Marga run toll roads, effective from the 7th of July until 5 days after Lebaran.

The government instructed toll road operators to make the cut to help out people during their long trip home.

In this post, I’m going to argue that, yes, this does save some of Indonesia's citizens money, but that it is inefficient, poorly targeted, and will cost the government (at least) a hundred million dollars over the next few years.

First off, how much does it save people?

I don’t have numbers on the amount of money this could cost toll road operators (which is the same as the aggregate amount that it saves users), but we can try to estimate a ballpark figure.

The tariff cut is in effect for 16 days, being 16/365 = 4.4% of a year. How much money the companies will lose will depend on the traffic flows. If traffic flows are heavier over that period than over the year as a whole, we’ll lose 25%/35% on more than 4.4% of a year, if they’re light then they will lose less than that.

To me, it seems plausible that they’d be heavy, because a large chunk of the country will be travelling over this period. But then, most toll roads are in Jakarta, and people leave the city during this period, and the flows might be heavy only for a few travelling days, while they’ll be light for a few days in the middle; this could mean that the flows are on average lighter. For this sort of analysis, it’s probably not too far wrong to just assume that traffic flows are, over the whole 16 day period, pretty much in line with the average flows over the year. In that case, we can just multiply the discount by 4.4% of the year, and find that private toll road operators should expect to lose around about 1.1% of their annual revenues over this period, while Jasa Marga will lose 1.5%.

I haven’t got data on the total fare revenue collections on all toll roads in Indonesia, but, in 2014, Jasa Marga’s receipts were around IDR 6.6 trillion and they control a bit under 60% of Indonesia’s toll road network. Assuming revenues roughly split that way too, we can estimate around IDR 4.8 trillion of non-Jasa Marga toll revenues. With a bit of growth and rounding, I’ll assume IDR 7 trillion for Jasa Marga and IDR 5 trillion for non-Jasa Marga toll operators.

So, as a result of this tariff cut, Jasa Marga will lose around IDR 105 billion (USD 8 million), and private companies will lose around IDR 55 billion (USD 4 million) in revenues. Toll road users will be better off by around IDR 160 billion (USD 12 million); the sum of those two amounts.

Just to reiterate again, this is a ballpark figure. It might be twice, it might be half, but it’s probably not 10 times, or 10% of that amount.

And who are the beneficiaries of this transfer?

The beneficiaries of this cut will obviously be the people that use the toll roads. So, who are they, and how much benefit will they actually get each?

Poor people will get some of the transfer, but not much. Poor people either ride motorbikes or the train, so avoid toll roads, or ride buses or “travels”, where their share of the toll is between one fifth and one fiftieth of the fee, depending on the number of people that are in the vehicle. If you have packed full a Toyota Avanza driving from Jakarta to Surabaya, taking every toll road on the way, both ways, your toll fees are about IDR 500,000. So, assuming 5 passengers with bags, the cost per passenger is about IDR 100,000. So, the saving to each poor person is about IDR 30,000 (USD 2.25). If the trip is shorter, or the vehicle is bigger, the savings will be smaller.

Even to a poor person, this is not much. A bus ticket to Surabaya around this time of year is around IDR 500,000, so you might be saving them 6% of their fare. This probably doesn’t even cover their food costs for the journey.

And, this is assuming that bus and travel companies adjust their prices at all. There is a lot of research that says that prices are sticky, so most likely the transportation companies are the ones that will get the windfall profit.

So, other than some poor people and transportation companies that serve them, you’ll have middle-class and rich people, who care even less about a savings of IDR 100,000 on their carload than poor people do about their IDR 30,000.

So, with this policy, the government extracted around USD 12 million from toll road operators, and spread it around a bunch of people that didn't really need it and won't even really notice it.

So why is this such a bad thing?

So, why am I making such a big fuss about this? How does costing toll road operators USD 12 million, most of which is borne by an SOE anyway, cost the government so much money? I’m going to deal with three reasons, as follows:

  1. It’s not fair;
  2. It’s operationally disruptive; and
  3. It sets (or reinforces) terrible regulatory expectations.

It’s not fair

There will be a certain group of people that will scoff at this: “Billion dollar companies can’t afford to give the average citizens a measly tariff cut for a few weeks?”

It’s true, the amounts are relatively small for a billion dollar company, but the point isn’t the amount, the point is that the government made a deal, and signed a contract, now they are unilaterally renegotiating it.

If we imagine a toll road which, in present value terms, will cost USD 1 billion, where the revenues will cover USD 900 million of that. To get it done, the government will have to pay a USD 100 million subsidy and the cashflows will look like the below, in present value terms.

When bidders bid on infrastructure projects in open tenders, they are bidding pretty close to the subsidy (tariff, concession fee, whatever the bid factor/balancing item is) that will exactly cover their costs and no more. They have to work as hard as they can to push down their capital and operational costs, put together the best financing package, convince their lenders to lend at the lowest rate possible, design the best/cheapest systems, and generally do everything they can to bid as cheaply as possible while meeting the minimum service standards. To win, you’re really cutting close to the bone.

So, any tariff cut or unexpected increase in costs, even a small one, means the investors will have lost money.

Imagine you are having lunch with some friends, then the President turns up and says “Surprise! Everyone’s lunch today is free!” then walks out, leaving the restaurants to bear the cost of your free lunch. This is pretty much what is happening here.

The concessionaire agreed to provide a service and bid their tariff according to a particular revenue projection, and all of a sudden, they’re being told that they aren’t allowed to charge what it says they are allowed to in the contract. That’s just not fair.

It’s operationally disruptive

The government has instructed an operator to cut tariffs; how much cash have they got in the bank?

If they have optimised their system, they’ll have as much as they need for that month and not a rupiah more. If they have any excess cash, they should use it to pay off their debts or dividends to their shareholders. All of a sudden, they’re being told that they’re going to lose 25% of their revenues for two weeks with no notice, and the banks are all about to go on holiday.

If a particular toll road operator loses USD 1 million, that means they need to scramble around to find this extra USD 1 million so that they can pay their employees’ salaries and keep the lights on. It’s not a massive amount of money for them, but it’s not easy to mobilise at short notice.

Toll road operators will also need to figure out how to implement a tariff cut with no notice. Tariff adjustments are things that they only expect every 2 years according to a schedule, so they have time to print up new signs, update their computer systems, figure out how much of every denomination of cash they stick in each toll booth, and so on. They, most likely, aren’t set up to change tariffs at a moment’s notice for a 16 day period.

Finding cash and implementing a no-notice tariff cut are not insignificant operational disruptions. Dealing with them will take significant time from the senior management, and probably the lenders as well. The cost of these disruptions is not included in the USD 12 million figure I estimated above.

It sets (or reinforces) terrible regulatory precedent

By cutting tariffs like this for one year in Lebaran, Indonesia has now created an expectation on the part of bidders that they will do the same in future. In Indonesia, for the next couple of years, faced with the same projections of cost and revenues, bidders will bid, discounting their revenues by 1.1%, accounting for the expectation that the government will force them to cut their revenues. For our billion dollar toll road above, going forward in Indonesia, the cashflows in present value terms will now look like the below.

The government will have to pay another USD 10 million in subsidy to cover the cost of the expectation that they created by cutting tariffs like this.

So how much will this cost the government in the long-run?

The government has 5 toll road projects in the “prospective” category of BAPPENAS’s priority project list, with capital costs as follows:

Manado – Bitung – USD 353 million

Tanjung Priok Access – USD 612.50 million

Balikpapan – Samarinda – USD 1.2 billion

Cileunyi – Sumedang – Dawuan – USD 1015.8 million

Pandaan – Malang – USD 420 million

The total capital cost of these toll roads is USD 3.6 billion. Assuming a capex/opex split of 60/40 and that land acquisition cost will be borne by the government, the total net present cost of these toll roads to the private sector will be on the order of USD 6 billion. Assuming no VGF, 1.1% of revenues needed to cover these toll roads represents USD 66 million.

So, future bidders in the toll road sector will “price in” the expectation that the government will force them to cut their tariffs during Lebaran. This price will be passed through to government through requesting a higher subsidy, or paying a lower concession fee; or through to users by charging a higher tariff.

In addition to the USD 66 million, investors will look at a government that is willing to surprise them with multi-million dollar losses not envisioned in their contracts, and expect that there will be a few more surprises as well. To cover this expectation, they will need to build an even larger margin of safety. It is eminently plausible that the margin the investors will assign to this uncertainty will be on the order of USD 100 million dollars.

The broader impacts

The expectation of regulatory intervention applies outside the toll-road sector as well. A government that is happy to force toll road companies to cut their tariffs might force private water operators to freeze their tariffs, apply arcane leverage constraints to airlines, or dramatically change the venues through which they can sell their product.

A government that acts erratically in its regulation is a significant driver of the country risk premium that investors and lenders will apply when deciding how to value their products in Indonesia. This flows through to the cost of finance, which is a component of almost every good in the country pushing up costs to all consumers, and harming the competitiveness of Indonesia's firms, relative to those in countries where the government does not take actions like this.

So, what can they do?

The damage isn’t necessarily completely done. If the government compensates the toll road operators for the gap between the tariff they normally charge and the one they’re being forced to charge, that would mitigate a lot of the impact of the expectations of regulatory meddling.

Even if they don’t do that, they can still mitigate some of the poor expectations by the way they design their concession agreements going forward. All they need to do is build in the right to cut tariffs whenever they want, but make it clear that they must give reasonable notice, and that the government will meet the gap between their agreed tariff, and the tariff that the government may choose to impose.

It will be interesting to see how the next round of tenders proceeds following this announcement.

Do governments deliberately over-state the cost of transport projects?

Lest anyone think that Indonesia is the only country struggling to provide and finance infrastructure, this article on Alan Davies' great blog, The Urbanist, covers the struggles that governments in Australia have in deciding what infrastructure to build and coming up with sensible cost estimates as inputs into that decision-making process.

There is often a pervasive myth that, if only we had the data, less corruption, or smarter politicians, we could find some perfect solution that would make everyone happy, grow the economy, fight poverty, and drive gender equality. Those things would certainly help, but there's still a whole lot of the problem that is hard in any country, not just Indonesia.


Note: If you're interested in these issues, The Urbanist is a really great blog to sign up to. He deals almost exclusively with Australian urban issues. But, even if you're not Australian, the way he breaks down the problems is applicable to any context. A good chunk of my blog is basically my impersonation of him! 

How Indonesia can deliver rural toll roads

Earlier this week, BAPPENAS launched its priority list of PPP projects for 2015, including 5 prospective toll road projects and 1 potential toll road project. Following the tradition, they have included Manado – Bitung in their list of projects in the pipeline.

I wanted to write about this project because it illustrates a few problems with Indonesia’s approach to PPPs in the toll road sector, and one thing they’re (hopefully about to be) doing right.

History of the Manado – Bitung toll road project

The Manado – Bitung toll road is a 38km road planned to link the coastal cities of Manado and Bitung to support their integration into a unified metropolitan area across the province of North Sulawesi. In the 2013 PPP book, the investment cost was estimated at USD 353 million. I’ve never been to either of the cities, but I understand that this is a longer-term plan, and that the existing traffic flows, while heavy for the existing road, will not remotely cover the cost of construction and operation of the sort of toll road that has been proposed.

In the market soundings I have attended and briefings I have read, people spruiking the project have talked up the potential of the Bitung special economic zone (“SEZ”) and the upgrading of the port to drive traffic growth. There is some information on the SEZ here, and the upgrading of the port here.

The Manado – Bitung toll road has been included in every PPP book ever published by the Indonesian government. It was tendered in 2014, but the tender failed when it emerged that the winning bidder had no experience at all in the road sector and no ability to deliver the project (if I remember correctly, it was also tendered at some point in the late 2000s, but I can’t find a record of it).

Like all toll roads in Indonesia, the Manado – Bitung toll road was tendered with the private party taking full demand risk, getting all of their remuneration via user charges. The existing traffic flows were low, but government asked investors to take into account the potential traffic flows that might arise when the SEZ and upgraded port were finished. Given the uncertainty around the timelines of the development of these two facilities, and the impact they may have had on usage, all of the serious bidders took a conservative view of the traffic flows and realised that there was no way they would cover their costs through user charges alone. As there was no subsidy on offer, the serious bidders elected not to waste their time, leaving only poorly qualified bidders like the one that won.

So, all we need to do is offer a subsidy?

As I noted above, there is a lot of uncertainty surrounding the traffic flows. Private investors will necessarily take a conservative view on the traffic flows, but, with a sufficiently large subsidy, the project should be able to be made financially viable.

If the government wants the project, is that the best thing for them to do?

I would actually tend to think that, no, in fact, that would not be the best thing for government to do.

Excessive risk aversion transfers value to the private sector

The traffic flows for the toll road are highly uncertain. The government thinks that the traffic flows will be great, because they will develop the port and the SEZ, driving traffic, and they will create a conducive policy environment that will spur development along the route, further increasing traffic. Unfortunately for the government, the private sector bidders do not believe this, as the government has no track record of delivering projects like this on time.

The graph below shows, a simple depiction of what the two different scenarios could look like.

In a toll road, you get the vast majority of your revenues from user charges. Assuming you’ve got a single tariff for all cars regardless of distance, your revenues are the number of cars that drive on your road, multiplied by the tariff, as simple as that.

In an infrastructure deal, you’ve got two kinds of cash outflows: capital expenditure (“capex”), and operational expenditure (“opex”). Put very simply, capex is the investment you make upfront, which is fixed, and opex is the cost you bear over time, which changes depending on your traffic. If more people drive on your road, you have to spend more on maintenance. It’s a bit more complicated than that in the real world, but this will do for now.

The government looks at the projected costs and multiplies their traffic flows by the tariff; the difference between the two is the subsidy they think will cover the cost of service. The private sector party uses the same cost estimate, but with a more conservative estimate of traffic flows, calculate that they will need a relatively larger subsidy. In present value terms, the graph below shows how that arithmetic works with some simplified numbers.

In my simplified example, the government think they’ll need a USD 75 million subsidy, and the private party think they’ll need a USD 150 million subsidy.

Unfortunately for the government, what they think doesn’t matter. They run a tender with the minimum subsidy as the bid factor, so all the bidders get together and try and figure out ways to lower their costs, and raise their revenues, eventually arriving at the minimum subsidy they think they can get the job done for. Whoever bids the lowest subsidy wins, so the winning bidder’s expectation of the costs and traffic flows is what determines the subsidy, not the government’s. And, that’s the way it should be.

Through running a tender process, the government is trying to get to what economists call “efficiency.” The efficient subsidy will be an optimisation of the lowest costs capable of meeting the service standards and the best guess at the traffic flows. Each bidder will bid a subsidy that covers their costs, including a reasonable return on their investment, and no more. If they bid more, they would run the risk of being undercut by the other bidders. If the tender process is free and fair, you should come pretty close to the minimum subsidy possible to get the job done.

But, what happens if, in fact, the government exceeds the winning bidder’s expectation and delivers the port and the SEZ, and develops the area around the toll road in such a way that the government’s projection of the traffic flows were realised. The private party already got their subsidy, so the high traffic volumes just mean that the private sector makes a whole lot more money. They got a high subsidy, representing the conservative traffic forecast, then the high revenues from the actual high traffic volumes. The graph below shows what the cashflows could look like in present value terms.

In this simple example, the private party ends up making an economic profit of USD 45 million in present value terms. This means, they ended up covering their costs, including a return on their capital, plus a nice return over and above that.

How can a tender process result in economic profits?

But how can this happen? I said earlier that the subsidy was “efficient”, and efficiency means you just cover your costs, no economic profits. How can a free and fair tender process end up resulting in such a large economic profit?

For starters, in a project like this, someone will always make an economic profit or loss, because you will never predict exactly how many cars are going to drive on your road. If you get only one more car travelling on your road than you expected over the thirty year concession, the tariff paid by that additional car represents your economic profit, if you get one less, that’s your economic loss. In an uncertain world, efficiency means making the best possible guess with the best possible information available at any given time.

The winning bidder bid on the basis of the best information available at the time. They could not have known that the traffic flows would materialise in the way that they did. So, while, looking back, we can say they made a large economic profit, at the time of bid, the expected value of that profit was zero. Unfortunately for decision makers faced with uncertainty, as we live in the present, we’ll just have to live with the swings.

When something like this happens and a private party is making a whole lot of money, governments sometimes try to renegotiate the contract, to claw back some of the economic profit that the private sector is making. In the world of risk, that’s what we like to call a “heads I win, tails you lose” situation. Let’s say I offer to bet you USD 100 on a coin flip, if I win, I take your money, but if I lose, I try and renegotiate and say that I didn’t know it was going to turn out this way. This is analogous to what government is trying to do in some instances when they try and renegotiate contracts to claw back profits when things go well. If the private sector party over-estimated the traffic forecasts and was making an economic loss, the government would not (or, at least, should not) have stepped in to let them increase their tariff or to pay them extra subsidy, but when it is going well for the private party, they step in and try to renegotiate.*

What other options do we have?

At the other end of the demand risk allocation spectrum, you have what is called an availability payment, where the private party actually can have no exposure to traffic flows at all. As a simple example of an availability payment PPP, imagine a private party with a fixed monthly payment that they get as long as the road is in the minimum specified condition. This payment is set during the bid process to exactly cover their capex over a 30 year period. If they let the road condition slip either by building it shoddily in the first place, or by maintaining it poorly, they won’t get their initial investment back. On top of that, they have a separate payment that they get per car which is designed to cover their opex and no more. Revenue collection may be handled by the private party, but that goes straight into a government account.

The graph below shows a simple example of the cashflows in PV terms:

The biggest thing you may note is that the costs and revenues are different. This is because an availability PPP is seen as much lower risk to the private party than a full demand-risk PPP, so private parties can raise equity and borrow from banks at much lower cost, meaning they don’t need to ask for as much money to cover their debt service and repay their equity holders. But, on the other hand, as the government is bearing the risk, they should also discount the revenues they expect to receive to reflect the fact that they are bearing more risk.

I’m calling the subsidy an “effective subsidy” here because it’s not a payment in the same way that the subsidy for a demand risk subsidy is. The payments are the fixed and variable payments, the subsidy is just the residual between those payments and the revenues, whatever they may be.

As I mentioned earlier, this puts demand risk on the government. If the revenues are less than expected, the effective subsidy will be larger than expected, and the government will have to find more cash to pay the private party’s payments than it thought it would. If the revenues are higher than expected, the government takes the whole gain.

So, which is better?

In one case, the private party takes the risk, in the other, the government takes the risk. How do we decide which option is right for us?

True efficiency also means efficient risk allocation

The most basic principle of risk allocation is that you allocate the risk to the party best able to manage it**. If neither party has any control over the risk, then it doesn’t really matter which party you allocate the risk to. In a mature city, for example, there may not be much the government can do to influence traffic flows.

In this particular case, however, there are significant public actions that will need to be taken in the next few years, the government has much more control over the policy levers that will drive the traffic, while the private party will have almost no ability to influence demand. Further, the government has no track record of delivering the port, SEZ and surrounding infrastructure. Indonesia has over-promised and under-delivered in infrastructure for decades. No investor is going to bet hundreds of millions of dollars that the government will suddenly spring into action and deliver faster than it has ever delivered before.

Too many investors, and would-be investors have been burned trying to invest in Indonesian infrastructure, so private sector traffic projections for a toll road like this will always be conservative. If the government truly believes that it can deliver the work program, and it wants to get the value of the traffic flows associated with the delivery of that work program, then they must take on demand risk themselves. 

Government officials here are very risk averse (for good reason), so when you offer them a choice between bearing a risk themselves, or allocating it to the private sector, the initial reaction is almost always to dump it on the private sector party. But, if the risk is one that they are truly the best party to manage, they will end up paying more, and maybe even transferring value to the private party by forcing the issue. To me, that's a worse kerugian keuangan negara (state financial loss), than any loss government might make by taking on demand risk themselves.

Note: I am simplifying it a bit by just saying “government.” In fact, the contracting agency for toll roads is BPJT, the party responsible for building the port is Pelindo IV, the party responsible for building the SEZ is the provincial government of North Sulawesi, and the parties responsible for developing Manado and Bitung are the respective city governments. So, the Indonesian government as a whole has the control, but coordinating all of the parties will be a big job. BPJT alone won’t have the authority to knock heads together, but they’ll have a lot more access to the people that do than a private party. If you hire someone to build a road, get them to build a road, don't ask them to build a road, and coordinate 5 different government entities. That's government's job.

What is the Indonesian government doing to rectify this?

Earlier this year, the government issued Presidential Regulation 38/2015 concerning government cooperation with business entities in the provision of infrastructure. This replaces an earlier piece of legislation, and the new regulation explicitly incorporates language providing greater flexibility for the government to undertake availability-based PPPs.

So, will we see an availability payment being applied for Manado – Bitung?

It’s too early to say. I hope so. I suspect it’s probably appropriate for a toll road like Balikpapan – Samarinda as well.

There has been talk about the use of performance-based annuity schemes (“PBAS”, which is just a fancy name for an availability payment) for the construction of non-tolled roads, but I haven’t yet seen any statement from BPJT on whether they intend to use this model for tolled roads as well. I guess we’ll see what they think when BAPPENAS finally publishes the PPP book with more information.


*Note that the proscription on renegotiating does not apply where projects were not competitively awarded. This happens a lot in resource projects in developing countries either due to information asymmetries, or straight out corruption (the New Yorker has an example of one here). Renegotiation or even termination could be the efficient outcome there.

**If you want to know more, a good treatment of this is in Tim Irwin’s book Government Guarantees, available in PDF here. Aside from the discussion of risk, it’s a fantastic resource for people in the infrastructure business.

BAPPENAS launch PPP priority project list for 2015

BAPPENAS, Indonesia's planning ministry, has published their list of priority PPP projects for 2015 by publishing BAPPENAS ministerial decree number 82/M.PPN/HK/05/2015 concerning the determination of the list of planned infrastructure projects for 2015

With 6 "ready to offer" projects this year, they're doing better than they were in the last book, launched in 2013, when they had zero projects in that category*. BAPPENAS do not appear to have launched their PPP book providing further details on the projects yet.

Indonesia has struggled in implementing its PPP agenda to date. So far, only one project has reached financial close (Central Java Power Plant), and no others have reached the award stage. Those currently under procurement do not appear likely to make it out the other end any time soon.

The reasons for the lack of success are varied and complex, but it all boils down to a lack of political commitment. I am hoping that this decree spurs more action than we have seen from the last few.

I list the projects from the decree below.

Ready to offer projects

I.1. TRANSPORTATION

I.1.1. Sea Transportation

Not Available

I.1.2. Air Transportation

Not Available

I.1.3. Railway

1. Soekarno-Hatta International Airport – Halim Railway

2. Bandung Light Rail Transit (LRT), West Java

3. Tanjung Enim – Tanjung Api-Api Railway, South Sumatera

I.1.4. Land Transportation

Not Available

I. 2. TOLL ROAD

Not Available

I.3. WATER SUPPLY

1. West Semarang Municipal Water Supply, Central Java

2. Pondok Gede Water Supply, Bekasi

3. Pekanbaru Water Supply, Riau

I.4. SANITATION

Not Available

I.5. TELECOMMUNICATION

Not Available

I.6. ELECTRICITY

Not Available

I.7. OIL AND GAS

I.7.1 Transmission

Not Available

I.7.2 DISTRIBUTION

Not Available

Prospective projects

II.1. TRANSPORTATION

II.1. 1. Sea Transportation

Not Available

II.1. 2. Air Transportation

Not Available

II.1. 3. Railway

1. Integrated Terminal of Gedebage (Railway), West Java

2. Development of South Sumatera Monorail

II.1. 4. Land Transportation

Not Available

II.2. TOLL ROAD

1. Manado – Bitung Toll Road

2. Tanjung Priok Access Toll Road

3. Balikpapan – Samarinda Toll Road

4. Cileunyi – Sumedang – Dawuan Toll Road

5. Pandaan – Malang Toll Road

II. 3. WATER SUPPLY

Not Available

II.4. SANITATION

Not Available

II. 5. TELECOMMUNICATION

Not Available

II. 6. ELECTRICITY

1. Karama Hydro Power Plant, West Sulawesi

II. 7. OIL AND GAS

II. 7.1. Transmission

Not Available

II. 7.2. Distribution

Not Available

Prospective projects

III.1. TRANSPORTATION

III.1.1. Sea Transportation

1. Development of Maloy International Port, East Kalimantan

2. Expansion of Kabil Port (Tanjung Sauh Terminal), Riau Island

3. Development of Kuala Tanjung International Hub Port

4. Development of Bitung International Hub Port, North Sulawesi

5. Development of Makassar New Port, South Sulawesi

6. Development of Baubau Port, Southeast Sulawesi

7. Development of Garongkong Port, South Sulawesi

III.1.2. Air Transportation

1. Development of New Bali Airport, Bali

2. Kulonprogo International Airport, DI Yogyakarta

3. Expansion of Mutiara Airport, Central Sulawesi

4. Expansion of Komodo Airport, East Nusa Tenggara

5. Expansion of Radin Inten II Airport, Lampung

6. Expansion of Juwata Airport, North Kalimantan

7. Expansion of Sentani Airport, Papua

8. Expansion of Tjilik Riwut Airport, Central Kalimantan

9. Expansion of Fatmawati Soekarno Aiport, Bengkulu

10. Expansion of H.AS.Hananjoeddin Airport, Belitung Island

11. Expansion of Matahora Airport, Southeast Sulawesi

12. Expansion of Sultan Babullah Airport, North Maluku

III.1.3. Railway

1. Development of Batam Railway

2. Pulau Baai - Muara Enim Railway, Bengkulu - South Sumatera

III.1.4. Land Transportation

Not Available

III.2. TOLL ROAD

1. Batu Ampar – Muka Kuning – Hang Nadim Toll Road

III.3. WATER SUPPLY

Not Available

III.4. SANITATION

1. DKI Jakarta Sewage Treatment Plant

III. 5. TELECOMMUNICATION

Not Available

III.6. ELECTRICITY

1. Tebo Mine Mouth Coal Fired Steam Power Plant (2 x 200 MW)

III. 7. OIL AND GAS

III. 7.1. Transmission

Not Available

III. 7.2. Distribution

Not Available


*On the plus side, at least it was more accurate than the 2012 PPP book that promised 3 "ready to offer projects" and the 2011 PPP book that promised 11. Of those 12 projects, only 1 was competitively tendered through Indonesia's PPP framework, Lampung Bulk Water Supply project, but the procurement process appears to have ground to a halt.

Saatnya didengar

Saatnya Didengar (Time to be Heard) is an initiative that aims to stimulate discussion about the problems that Indonesia's citizens face resulting from the poor state of the nation's infrastructure. It is being run by Infrastructure Asia, the organisers of Indonesia Infrastructure Week 2015, coming up in November, in cooperation with the Centre for Sustainable Infrastructure Development at the University of Indonesia.

Their big initiative so far is a do a nationwide social media survey, trying to find out what problems Indonesians see with their nation's infrastructure, and what they want to see done about it. The survey is almost complete, but you can still fill it in here, until August 10, 2015 if you've got something you want to say. They'll be taking the message to the President once they collate their results, and, hopefully, publishing them more widely too. 

They're doing a great job of promoting it too. They had a big concert at the end of last year's Indonesia Infrastructure Week, with some big name stars, like Anggun, and they're giving a pair of round trip tickets to anywhere in Indonesia on Batik Air to one lucky respondent to the survey every week.

I love this initiative, and I think they're doing a great job of making the message accessible, and trying to create impetus for action on the part of the Indonesian government. 

I'm looking forward to seeing their results!

ModelOff 2015

I came across ModelOff on LinkedIn last week and thought it was a great initiative. They call themselves the financial modelling world championships and have been running since 2012.

As I mentioned in my last post, getting real world experience applying quantitative analytical tools to a wide range of problems is one of the best things you can do for your career; especially early on. From what I have seen, their collection of past questions available on their website are a really good mix of the sort of range of problems that you come across as a financial/economic consultant.

I must say, I am tempted to register for this year, but, I'm not really in game shape at the moment. Sadly, I spend more time working with Word, and Powerpoint these days than Excel.

Whether you want to sign up or not, if you're interested in improving your modelling skills, have a look through their problems and give them a crack.

Numbers matter, but... Balancing quantitative and qualitative factors in decision-making

A lot of my blog posts so far have been about the need to understand the relevance of political processes, values and the importance of qualitative judgments in decision-making. I’m certainly not the sort of guy you’d accuse of being against quantitative analysis—I’m a huge fan—however, it doesn’t explain everything and thinking it does can be incredibly dangerous. In this post, I’ll make the case for taking the time to learn quantitative skills, but also talk about how and why they can be a double-edged sword.

Quantitative skills are really important and valuable

While both quantitative and qualitative analytical skills are really important, the reality is that in the field of policy and government generally, you find a lot of people that have always operated at a pretty high level of abstraction. They might be masters of qualitative analysis, but few of them actually have direct experience undertaking really solid, robust quantitative analysis. This scarcity means that people that can do and understand quantitative analysis at a deep level are extremely valuable.

One of the most common pieces of advice I give to people in the early years of their careers in my field is to get up to their elbows in quantitative analysis as quickly and as often as they can. This is especially important early in your career because applying these techniques to the real world takes a lot of trial and error (and there are a lot of errors). When you get more senior (and more expensive), people are less willing to have you sit around with a model for days at a time trying to figure out why you can’t get your balance sheet to balance.

I like to say you’re not a real modeller until you have been standing in front of a room full of important people presenting your findings and someone asks a question that makes you realise you have made a mistake in your calculations. If you do enough modelling, this will happen. Better that it happens earlier in your career than later.

If you’ve never done the analysis yourself, you won’t have the same feel for how outcomes change. Certain questions that you might think are impossible, are, in fact, easy to answer. Conversely, certain questions that seem trivial, are really, really hard. Knowing the difference can save you lots of time and money.

This comic is from one of my favourite webcomics, Xkcd. Click through for the alt-text.

This comic is from one of my favourite webcomics, Xkcd. Click through for the alt-text.

How big an impact will the exchange rate have on this project? Can we save money if we make the project smaller? Will giving the industry an allowance for accelerated depreciation help them expand more quickly? Why do we need to index this portion of the payment to the coal price? These are questions that get asked by important people when they are trying to make important decisions. If you have done a whole bunch of number crunching in the relevant sector, you might be able to answer these sorts of questions in seconds, or at least promise an answer within a reasonable timeframe. If no one in the room understands the numbers, most likely the questions will get answered incorrectly, or forgotten about and you increase the chance that you’ll get a bad outcome.

Quantitative analysis is not all that matters

In the real world, there's almost no such thing as a purely quantitative problem. Even if your client has asked you to build a simple financial model, given you all of the inputs, as a good modeller, you should make sure they understand the implications of their choices of inputs. How might the outputs vary if you choose different inputs? Are there hidden assumptions or logical flaws in some aspect of the model?

Your mathematical calculations may be perfect, but you need to be able to take a step back and think about how your numbers relate to the real world. For example, someone might ask you to run a scenario in your public transport model with high ticket prices and high ridership. Your model can certainly do the mathematical calculation, but is it likely that you will be able to get high ridership at the high prices assumed? What happens if you assume this and you’re wrong? Who bears this risk? What are the societal impacts of charging those higher ticket prices?

As I said earlier, there are relatively few people that can do sophisticated quantitative analysis, but among that population, those that really understand the real world implications of the models they make are rarer still.

Comic from Saturday Morning Breakfast Cereal, one of my other favourite webcomics. Click through for the alt-text. You could definitely replace "engineers" in the comic above with "finance professionals", or "economists"...

Comic from Saturday Morning Breakfast Cereal, one of my other favourite webcomics. Click through for the alt-text. You could definitely replace "engineers" in the comic above with "finance professionals", or "economists"...

There’s nothing more dangerous than a genius with a model. When they’re wrong, which will happen, it will be hard to find out. Partly it’s hard because they may have used complicated techniques that are difficult to follow, but it’s also hard because they tend to be certain that they are right, and might scoff at the idea that mere mortals could identify a problem with their analysis.

When I think about my most valuable employees, colleagues and bosses, the best ones are those that have strong quantitative and qualitative skills. Following them, I'll take strong qualitative skills alone before I'll take strong quantitative skills.

The Nusantara Economics matrix of employee value

The Nusantara Economics matrix of employee value

If I’m forming a team of Bs and Cs, following the Nusantara Economics matrix of employee value above, I’ll definitely put a B in charge, because they are the ones that do real-world sense checks, and can communicate the analysis to the client or counterpart.

Striking the balance

You can cause problems by either over-weighting quantitative or qualitative concerns in decision-making. The sub-prime mortgage crisis is a pretty galling example of the former, while Indonesia's insistence on being self-sufficient in beef is an example of the latter.

When you look at a problem, you'll need to determine what the appropriate balance of quantitative and qualitative factors will be. For something like how determining the alignment of a power transmission line, maybe its 80/20 quantitative/qualitative. For something like designing standard operating procedures for how child protection services engage with families of abused children, it's probably 10/90. The right balance will be different for every problem, and will even change for the same problem over time or in different contexts.

If you recognise this, and actively seek to find the right balance of quantitative and qualitative factors in your analysis, then I think you'll have the best chance of delivering great analysis that helps people make the best decisions in truly difficult circumstances.

Should you give resettled people equity in toll roads as compensation?

An official in BAPPENAS, Indonesia’s planning ministry, was quoted in a few different papers last week saying that the Indonesian government wants to promote what they call public private people partnership (P4), by giving people that are resettled ownership in the toll roads replacing some portion of their cash compensation. Is this policy a good idea?

In short: no. It is a truly, truly terrible idea.

It doesn’t solve the core dispute

Land acquisition is slow in Indonesia because people either don’t want to move at all, or they don’t like the price being offered for their land. Let’s say you’ve got some guy, Mas Joko, that you have offered IDR 100 million for his land, which he has rejected. “OK”, you say, “how about we offer you shares instead?”

Of course Mas Joko’s first question is going to be “what’s the value of the shares?”

If your valuation of the land is IDR 100 million, then that’s the value of the shares you’re going to offer him. In which case, why should he view the offer any differently?

If you decide that you can pay him more in shares than you can in cash, say, IDR 150 million, then if that is indeed the true value of those shares, you are actually paying him IDR 150 million in cash because you could have just sold the shares on the market yourself, then paid him IDR 150 million in cash. If you couldn’t have sold those shares on the market for Rp. 150 million, then that isn’t the value of them and you’re trying to scam Mas Joko.

Paying people in equity doesn’t make the process of negotiating the value the land any easier; which is the core problem.

Poor people will not be able to (and should not) use it

The risk and cashflow profile of equity in a toll-road is dramatically different from cash.

Let’s try and help Mas Joko try to choose between IDR 100 million in cash and IDR 100 million in equity in the toll road company. He’s not a rich man. He’s got a small plot of land that he inherited from his father, with a house that he lives in with his wife and two kids. Whatever he accepts, he’s going to need to find suitable housing for his family pretty much immediately.

With IDR 100 million in cash, he can go any buy another place straight away and, hopefully, live his life much as he was living it before he got resettled. Let’s look at how his life might be different if he were to take the equity.

The first thing you need to know about equity is it only pays out money if the company pays dividends, which only happens if the company is making a profit, which can only come when the company starts operating and everything is going smoothly.

So, lets look at the cashflow profile first. If he takes the equity, Mas Joko will need to wait until the rest of the land acquisition is done, then for the construction to be completed and the road to start operating before he has any chance of getting any cash at all. Looking at the Cikampek-Palimanan toll road that just started operating last week, land acquisition took 6 years (which is unusually long), while construction took 2.5 years (which is about right). Even assuming land acquisition will now be a breeze with their genius new policy, Mas Joko will need to wait at least 2.5 years until he has a chance of getting any money.

What is he meant to do in the meantime? Where will his family live? They haven’t got the capital to buy a new house because it’s all tied up in shares, so they’ll need to rent somewhere. Do they have the income to afford to rent? Previously, their housing was “free” (zero marginal cost) because they already owned their house, so the entire family income was available for non-housing consumption and savings. Now they have to find enough room for rent in that family income, so—assuming they can even afford it—either their consumption or their savings will suffer.

Equity is also dramatically different to cash in its risk profile. Cash is pretty close to zero risk. As long as it doesn’t get stolen and your bank doesn’t go belly-up, it goes straight to your bank account and stays there, accruing interest until you find something to do with it. Equity in a greenfield toll road is a completely different ballgame.

The BAPPENAS official was quoted by Kompas as saying “every big project that involves the private sector is usually always profitable.” This is patently untrue. Toll roads with demand risk, in particular, have been performing very badly over the past few years. So many were going bankrupt (meaning the equity holders lost part or all of their money) that the Australian government asked the Productivity Commission to conduct an inquiry into the financing of infrastructure to see what needed to be changed in the industry. Closer to home, the MNC group don’t sound like they are very happy with their investments in the toll road sector. By taking an equity position, you are taking on the risk that the cashflows you might get from the project will be delayed, or may even not materialise at all.

One of the ways in which poor people are fundamentally different to non-poor people is that they’re much closer to the bankruptcy line at any given point; they’re severely constrained in their liquidity. A single shock, like a family illness/injury, or a drop in income can be disastrous. As a result, they become incredibly wary of anything that harms their liquidity or increases their risk exposure. In fact, this proposal to give people equity instead of cash both harms their liquidity and increases their risk exposure! No poor person would (or should) take equity over cash.

Calling this a P4 and talking up the benefits for the people is a joke. The only people that would even remotely consider taking this up would be the richest of the rich, big companies, or government entities. No poor person would take it up, let alone be guaranteed to benefit from this.

Implementation would be a nightmare

I have already dealt with the problem of valuation above. Even assuming you get everyone’s land valued appropriately and converted into equity, they now become part-owners of the project. How do you integrate their rights and responsibilities as minority shareholders into the project going forward? How do they make sure that the project is distributing dividends in the way that they want? How do they make sure that the board, that is responsible to them, acts in the way they want? How do they make sure they don’t get forced out, diluted, or otherwise screwed by the dramatically larger shareholders?

Indonesia does have minority shareholder protections built into law, but in practice, they’re very hard to enforce, and doing so costs a lot of money in legal fees. Will the people that take this equity have the time, money and understanding to mount a legal defence if they feel like they are being mistreated?

Then, if you are protecting the minority shareholders, how do you make sure that the company can still operate? Indonesia’s banking penetration is currently around 20% to 30%, depending on who you believe. Most likely these minority shareholders aren’t going to be the most financially savvy investors ever. It’s not fair to expect them to provide meaningful oversight, and it’s not fair to the company to feel like they have to explain every decision to hundreds or thousands of people that have most likely never heard of the concept of corporate governance.

Also, part of the benefit of getting the private sector involved is that they bear the risk if they go bankrupt. If the toll road were to be in trouble, would the government let it go bust, taking away the savings of the poor minority shareholders with it, or would they bail them (and the private company, whose incompetence led to the problems) out?

This sort of thing is immensely complex, and if there’s one thing the government of Indonesia doesn’t need in its infrastructure agenda it’s more complexity. Let’s do some simple projects first before trying to solve something as complex as the protection of minority interests.

In summary

This proposal will not solve the problem. Land acquisition is hard, but the solution is not to come up with ever more complicated schemes and try and give them catchy names that sound like they are benefiting the poor. The solution is to deal with people fairly and firmly, and the existing regulations, while not perfect, are adequate for that purpose. Indonesia is facing an infrastructure crisis, and the government’s endless tweaking of regulations and a lack of focus on actually delivering projects is a key part of why.

All of the quotes about this policy seem to have been from a single event, hopefully it was just an off-the-cuff comment that will not actually see implementation. I am certainly hoping so, and looking forward to seeing more progress on real projects.


Note: This post has been edited for clarity. 15:08, 24 June 2015, WIB.

Why energy prices are a test of government leadership

I have been enjoying Matt Rennie's LinkedIn posts about various topics relating to the energy sector. Matt is a former colleague of mine at Ernst and Young, and their Global Leader for Utility Market Reform and Unbundling.

His latest post talks about topics I have covered in this blog so far about trying to balance economic efficiency with equity and access. From his post:

For governments, the challenge is to create an environment conducive to reform while managing social equity. A fine balance must be struck between:

  • Obtaining the economic growth benefits of long-term movements towards cost reflective retail tariffs by segment, caused by more accurate price signaling
  • Ensuring that vulnerable segments of the community — particularly susceptible to impacts in tariff changes — are protected against hardship

Source: Why energy prices are a test of government leadership, Matt Rennie

When Matt says that energy prices are a test of government leadership, he is underlining the fact that politics is an integral part of determining the optimal tariff structure. A government with a strong mandate from its citizens will have a much easier time convincing those citizens that its balance of cost-recovery and equity is the right one, than a government that is distrusted by its citizens. A good adviser will know how to run the numbers, but also be able to help governments think through ways to take into account their political context to make the right decision.

If you are interested in reading more about these issues, I recommend following Matt on LinkedIn.

What is the government's job in infrastructure?

The government’s job in infrastructure is to ensure the right infrastructure is delivered by the right party at the lowest cost.

I chose each of the underlined words quite carefully, so in the rest of the article I'm going to explain what I mean by each. 

The right infrastructure

The right infrastructure means that it is the right stuff in the right places and built to the right design standards. By right, I don’t mean some sort of “international best practice” right, I mean right according to the society that the government represents. 

If the society wants a road, and they want it enough to forgo the other things that they might otherwise spend the money on, then the government should give them a road that meets their needs (subject to their budget constraint).

While the road should meet society’s needs, it’s also important that it’s not over-engineered, or “gold plated.” In Australia that might mean the seats on a bus will be padded, and wide enough for an average Australian rear end, while in Indonesia, it might mean they are hard plastic and wide enough for an average Indonesian rear end. Giving everyone first-class aeroplane seats on a commuter bus might be comfortable for the passengers, but it most likely wouldn’t represent the best use of society’s resources.

 

Societies are made of up people with different preferences, and some might want fancy chairs, while others would prefer a cheaper solution and are happy for everyone to ride on hard wooden benches to get it. Picking a level of service is always going to upset someone, but generally, when governments do it, they are trying to achieve some sort of middle ground that makes the least number of people (or the least number of people they care about) unhappy*. That’s generally as close as you can get to the ideal of the right infrastructure.

The right party

In a modern, open economy, people get their services through a range of delivery modalities, including:

  • fully government, in which the government is wholly responsible for the delivery of the service. Imagine a government building a road with equipment and materials it owns directly using its own employees. A more common example would be the core functions of the military.
  • government contracted, in which the government contracts for the delivery of the services. This could be a government hiring a contractor to improve a road on a 6 month contract (a common type is an EPC contract), or one to build, operate then transfer a port as part of a PPP on a 50 year concession.
  • government regulated, in which the government doesn’t own or contract anything directly, but generally oversees the provider, or providers of the service. This encompasses a huge range of models. Some examples are below:
    • Heavily regulated: A fairly closely regulated example is in the New Zealand power sector where the Electricity Authority creates the market rules, enforces them, and monitors performance. 
    • Loosely regulated: Businesses like management consulting firms are generally quite loosely regulated. They still need to comply with laws and regulations surrounding the general practice of business, hiring, firing, workplace health and safety, taxes and so on, but there aren’t many specific regulations targeting the industry. Note that this can vary depending on the kind of advice being provided, for example, tax and financial advisers have more stringent guidelines than strategy advisors (or economists).
    • (almost) no regulation: Businesses like kaki lima (roaming street food vendors) in countries like Indonesia. In Indonesia, technically they’re meant to have licenses issued by the local Camat, but many don’t. Even if they do get licenses, they’re still exempt from many other regulations by virtue of their size. And, even if they’re not exempt, in practice, no one is going to check whether a kaki lima vendor is paying her employees properly**. Even so, it's not strictly accurate to say that they are not regulated.
A lightly regulated industryImage source: Wikimedia

A lightly regulated industry

Image source: Wikimedia

These delivery mechanisms are not mutually exclusive. There are plenty of industries where the government uses all three delivery mechanisms. In Australia, local councils own childcare centres, contract private parties to deliver childcare services, and oversee compliance with regulations for fully private providers. In Indonesia the government owns and operates hotels, and regulates private providers within the hotel industry.

What I’m getting at by describing all of these delivery mechanisms is that, in most cases, it shouldn’t matter who it is that provides the service, as long as it gets provided well. Governments should look at all the pros and cons of all of the different delivery models for the service they need and make a choice on that basis.

The lowest cost

By “the lowest cost” I mean that I don’t want to pay any more than I absolutely have to for my right infrastructure***. When I talk about paying, I mean either directly through user charges, or indirectly through government spending money that they might spend on other things that I want for society.

If the government is operating a water network and the private sector could do it to the same or better standards at a lower cost, then I want government to either match that cost, beat it, or hand the project on to the private sector and act as regulator.

Similarly, if a private operator of an airport is abusing their market power to charge exorbitant parking fees, then I want the government to step in to penalise them for it.

When contemplating engaging the private sector in the delivery of infrastructure services, it’s generally considered good practice to develop what’s called a public sector comparator (PSC). A PSC compares the cost of public provision with the cost of private provision, taking into account the upfront and ongoing direct financial costs, economic costs or benefits, risks that could be transferred or retained, and competitive neutrality (which I’ll come back to in a later post). If a private option is cheaper than the government provision, then you go ahead with the private option, if not, stick with government.

Conclusion

So, the governments job is to give us the right services, cheaply, by whatever means creates the most value to society. 

The process that governments go through to determine that they are ensuring the delivery of the right infrastructure at the lowest cost is not a linear one. You can’t just go through and try to answer the question of who should be delivering in isolation of the design and cost, and vice versa. In the delivery of a major project, there are typically years of work going through multiple cost estimates, evaluating different delivery mechanisms and engineering solutions, all feeding in to the coordination process that, ideally, produces an outcome in line with what we want from our governments.

An interesting approach to making the process of delivering infrastructure is more transparent has been pioneered by the Department of Treasury and Finance in the State of Victoria, Australia and is called the Investment Management Standard. If you’re interested, you can read about it more here.


*Considerations of access are an example where it's generally considered good practice to not weight all individuals' preferences equally. Ensuring wheelchair accessibility for things like public transport is a significant additional cost and is only required by a tiny minority of the population. However, as societies get richer, they increasingly feel like this is an appropriate cost burden for society to carry for the sake of this minority.

**It’s not all good by any means. The lack of regulation is accompanied by a lack of protections as well. Informal sector actors have little recourse if they are shaken down by local criminals (or government representatives), or if they get hit by a car, etc.

***My desire for low costs is, of course, in direct conflict with my desire for good services. The best outcome will be an optimisation of both. 

Remedy period over, Kanci - Pejagan toll road is being repaired

In my maiden blog post, I wrote about how the MNC group had been called in default of their obligations under their concession agreement by Indonesia's Toll Road Regulatory Authority (BPJT) and had been given a 90 day rectification period. In the articles I linked to in that blog post, the MNC Group seemed to be trying to deflect blame for the poor condition of their road, even though, under their concession agreement, they alone are responsible.

Bisnis.com reports that the rectification period ended on the 17th of May and PT Semesta Marga Raya--the holding company for the road--seems to still be in control. Bisnis.com reports that the road surface is still not in great condition and that substantial works are ongoing, but the fact that they are still in control suggests that they have either met the minimum required standards for road quality, or they have convinced BPJT that they will do so within a reasonable timeframe. The President Director of PT MNC Infrastruktur Utama, Syafril Nasution, confirmed that works are ongoing and that they have spent IDR 80 billion on rehabilitation of the road so far.

I haven't seen a public record of what the MNC Group spent buying this toll road, but it was most likely something on the order of the IDR 2 trillion. If they hadn't foreseen this expense, they're looking at something like a 4% loss, even more if the IDR 80 billion doesn't include all the spending they will need to do to get the road up to standard. This is a pretty significant loss in the infrastructure business.

It seems like, in this case, BPJT has done their job well. They identified a problem and used the remedies available to them under the contract to force their concessionaire to solve the problem. I'm sure this is disappointing for the MNC Group, but this is how the infrastructure business is meant to work.

To me, this is an encouraging sign of Indonesia's growing maturity as a recipient of private investment in its infrastructure. BPJT, as the regulator, is establishing precedents for how it acts in holding concessionaires responsible for their obligations under their concession agreements*. A consistent track record of fair and balanced regulatory judgments is a very valuable thing in attracting the kind of infrastructure investors Indonesia wants when it finally gets around to tendering the next round of PPP toll road projects.


*Of course, we need to look at how BPJT acts in situations where the penalties or benefits are in the concessionaire's favour too. I hope they are as quick to enforce the contract in those instances!

User pays, or why public transport shouldn't be free

One concept you hear a lot about in the discussion of public services is “user pays.” This means that, as far as is productive, we should seek to impose the costs of a service on the users of that service. As always is in economics, there are some counterbalancing effects, but let me explain what “user pays” means and why it is a useful concept, then I’ll get in to the limitations.

Why user pays is good

It is very common for public services to not cover the full cost of their provision. In every country I am aware of, petrol taxes and car registration don’t remotely cover the cost of construction and maintenance of the road network. Even in the USA, a country famous for the high private cost of healthcare, the government pays the majority of costs every year. All over the world, water tariffs rarely cover the full cost of service

When the users don’t pay for the full cost of the service that society feels is necessary, the government must make up the difference from the pool of money it uses to fund other services. So, by putting money towards, say, water, you’ve got less money available to fund childcare, the military, arts grants, roads, libraries, tax breaks, or whatever else you like government to allocate resources to.

This can be a bad thing because it represents a wealth transfer from people that don’t use the service to people that do use the service. This is well-illustrated by public transport. I’ll use Melbourne, my home town, as an example, but this analysis applies to, say, Sydney, Singapore, Tokyo and most other cities I’m aware of with well-established well-maintained, highly-patronised public transport.

In Melbourne, the public transport system is based around trams, trains and buses. Trams and trains are mainly laid out in what is called a hub (the city centre) and spokes (various points around the periphery of the city), while buses operate mainly along radial routes. It’s a pretty comprehensive system, but according to a 2009 survey, “approximately 8.8% of the greater urban area and approximately 448,000 residents were serviced within 30 minutes of anywhere in the greater Melbourne area. This concluded that only 10–15% of the residents in Melbourne are serviced by appropriate and timely public transport.” 

Now, not all of these 10-15% of people ride public transport, and some of the 85-90% do ride public transport, but the 10-15% enjoy a disproportionately high share of the benefits from the subsidy to public transport. In fact, even if they don’t ride the trains at all, the 10-15% still benefit from increased property values associated with good access to public transport.

This might be OK if public transport users were disproportionately poor, but that’s not the case in Melbourne. Melbourne train and tram lines have been there for a long time, and because they’re pretty good, property values in areas with good access are higher than those with poorer access. The hub (the city) of the network is also the CBD, where the highest paying jobs are, further compounding this impact. As a result, people that can afford to live in areas with good access to public transport tend to be richer.

The very richest few percent will drive their own private cars, but even with those people removed, the ridership of Melbourne public transport is disproportionately wealthy compared to the general population*. And this is just talking within Melbourne, in fact, public transport subsidies are paid by the state government, so you're taking money out of the pockets of all Victorians, and handing it out to disproportionately wealthy, urban Melburnians.

How much is this wealth transfer worth? It’s a bit hard to estimate, because it combines operating subsidies, and capital expenditure, which can be lumpy depending on the year. In 2013, BITRE estimated total payments to Metropolitan tram, train and bus providers to be almost AUD 2 billion for the 2013 financial year, with farebox revenues covering approximately 30% of that amount. So, society as a whole bears, on average, 70% of the cost of a user’s trip, which represented around AUD 1.4 billion in 2013.

Most of us can agree that public transport has great benefits in decreasing congestion, and providing access to some proportion of poor people, but it’s hard to argue that cost recovery should be any less than it is currently across the whole population.

The limits of "user pays"

There are many cases where having direct users pay the full cost of service is a bad thing. Sometimes it’s just impractical; for example, how would you allocate the cost of running the military, or the diplomatic corps across society? In many cases there are positive externalities, like better overall health for society by having cheap access to healthcare. Or, we might just not like to be the kind of society that charges for access to public parks and libraries. If you were to charge the full financial cost for these activities, you might get outcomes that you don’t like.

I don’t know enough about the efficient costs of running Melbourne’s public transport network to say whether the current costs are inappropriately low or high, but assuming they’re pretty close to the mark, based on the 2013 numbers, we’d need to more than triple our farebox revenue to cover the full cost. Given higher costs would mean ridership would suffer, fares would need to more than triple.

It’s very possible that you would lose so many passengers that there would be no tariff at which Melbourne’s public transport network would cover its costs. Of course, that doesn’t mean we shouldn’t have a public transport system as there are a number of positive externalities that people can point to that might justify the subsidy.

  • Less congestion: More riders means less congestion, which means all of Melbourne gets around to where they need to get to more quickly. This means people in Melbourne get to spend less time travelling, and more time doing other activities that are relatively more valuable to society. As Melbourne generates most of Victoria’s GDP and taxes, this benefits Victorian society as a whole.
  • Cheaper (to society) than car ridership: We also need to compare transport costs with the next best option, and the cost to society of driving a car is higher than the cost of public transport. As road subsidies aren’t likely to change substantially any time soon, you need to price your public transport in that strategic environment.
  • Enhancing access: While the relatively richer disproportionately ride public transport, there are also a significant number of poor people for whom public transport represents their only access to certain parts of town. A subsidy to provide access to those people would seem appropriate to many.

Where externalities are particularly strong, you sometimes even see government paying people to access services. In April This American Life had a story on their podcast about a government program in Richmond, California that paid criminals in cash to turn their lives around. This is the very opposite of a strict interpretation of user pays. You’re finding people that are creating problems for people, and giving them cash out of everyone’s pockets. Yet, by This America Life’s report, it was extremely successful.

The balance

So, how do you know what you should make people pay for and how much they should pay for it?

I like to think that my definition of user pays already incorporates this idea of balance. Above, I said that as far as is productive, we should seek to impose the costs of a service on the users of that service. It is the job of government (and those of us that help them) to figure out what “as far as is productive” means, and try to use the pricing policy to achieve it.

In my experience, for public transport, and many forms of economic infrastructure, the socially optimal user charge is rarely zero.


Footnote: You can try to have it both ways, and many countries do, with price discrimination. The most extreme version I have seen of this was when I was in Mumbai in 2001. First class tickets on their commuter rail got you access to a (dramatically) less crowded carriage, with nicer cushions on the seats, but the tickets cost about 10 times the price of regular tickets!

Melbourne, and all Australian cities that I am aware of do something similar with concession fares for the young, pensioners, etc.


*I’m sure I have read a study showing this, but I can’t find one at the moment. If you find a link supporting (or challenging) this, please let me know.

If you're making a real financial model, don't make this simple mistake...

This is the first  of what will probably be a series of pretty technical posts dealing with some of the nuts and bolts of infrastructure finance and economics. I don't want to do too many of these, but there are a few things that I figured out that took me a lot of blood, sweat and tears that I'd like to save some others if I can. If you're not in the business of making or using financial models on a regular basis, please feel free to skip this one!


When you build a financial model, there are two ways you can manage your numbers: real, and nominal. In real models, you pick a base year, and do all your calculations using constant real dollars, rupiah or whatever currency you’re working in. In nominal models, you need to adjust all of your numbers by the relevant inflation figure.

Whether you use real or nominal is largely a matter of personal taste. They are (or, at least, should be) mathematically equivalent. It’s more a matter of presentation. I have always been a bit of a nominal model man. The first professional model I ever took over from someone was a nominal model, and I guess that shaped how I think about these things, but, at least theoretically, I don’t mind much which flavour you want to use.

I said “at least theoretically”, because in practice, I have had lots of problems with real models. In fact, a significant number of the real models I have come across in my professional career have had the same glaring mistake. Take a look at the simple models below and see if you can see what it was.

Let’s imagine you work for the government and your boss wants you to analyse an infrastructure project to find out how much a private party will charge users to provide the service.

The project will operate at full capacity for a 10-year period providing a service for which it charges a tariff and incurs operating expenses that both increase with inflation. The business is pretty capex heavy and the capex is all incurred in the first year of operations, then depreciated on a straight-line basis over the 10 year operating period. You’ve got some cost estimates, and a pretty good idea of what the weighted-average cost of capital is for businesses in this industry, so you put all the costs in and run a goalseek to get your full-cost-recovery tariff.

First you make a real model (but unknowingly, make a mistake in its design). See below:

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 Then you make a nominal model to check your work (which doesn’t have the equivalent mistake). All you need to do is adjust the WACC, your revenues and your opex by inflation; everything else flows on from those.

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 You are alarmed to see that your full-cost recovery tariff is different between the two models that should be mathematically equivalent. What have you done wrong?

 Have you found the mistake? Last chance…

….

….

….

The mistake is in the depreciation. In the real model (and in a significant proportion of real models I have seen in the real world) depreciation has been assumed to be constant. In fact, straight-line depreciation is constant in nominal terms, and decreases in real terms. The 50 units of your year 1 capex that you depreciate in year 10 is worth a lot less in real terms than the 50 units of the capex that you depreciate in year 10. This doesn’t affect your pre-tax cashflows, but, if you keep the depreciation constant, the tax shield impact of your depreciation is overstated.

Here’s the real model with deflated depreciation that results in the correct full-cost-recovery tariff.

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 This effect of this mistake is not always very large, it’s only so large here because I used an example that was particularly capex heavy, but it can have a significant impact on decision-making in businesses like infrastructure where profit margins are very slim.

People think that in a real model, they don’t need to assume inflation. This is true if it’s a pre-tax model, but in a post-tax, or vanilla model, you still need to assume an inflation rate to calculate your depreciation correctly (and amortisation, etc.). So, I said earlier that it was largely a matter of taste what sort of model you make. That’s true, but if you’re building a real model, which is anything other than pre-tax, I might question your taste… Having to assume an inflation rate for a real model, to me, should make you question why you are using a real model in the first place.

So, now you know. Next time you see a real model, have a look at the depreciation, and let me know if you find the same mistake. The ones I have found have been made by very successful, multi-billion dollar companies, so the people making these mistakes aren’t in bad company, at least…


Gender and infrastructure

In my previous post I delved into the thorny issue of gender and infrastructure. It's something I have been thinking about a lot recently, both personally and professionally. 

It's the kind of area can sound a little odd. I mean, let's be honest here, the gender impacts of the alignment of a power transmission line aren't really immediately obvious. That said, in certain cases, like public transport policy, there can be some really significant positive or negative gender impacts.

In my experience, gender in infrastructure has been viewed through a sort of a safeguards lens, where you plan your project, then check afterwards if there are any negative gender impacts. If so, depending on how much they cost, you might do something about them. I'm interested in whether that is in fact the best way to do things, or if there's some other way. And, if there is some other way, how we can build systems that incorporate these issues from the ground up.

In Indonesia, pretty much the only people I know that are looking at the practice of this sort of thing are the Indonesia Infrastructure Initiative (IndII), an Australian government-funded program*. They have some great materials on gender and disability and are actively incorporate these issues into their program design.

I have also been lucky enough to have a chance to discuss this topic with Dr. Lisa Cameron of Monash University in Melbourne, whose work on Indonesia I have loved for a long time and highly recommend. I'm hoping she sees fit to add to the academic literature on this sort of thing...

Outside of this, and what I have found with a bit of a google, I'm not that aware of many good resources on the topic. If anyone knows of any good research or interesting researchers looking at this field, please let me know in the comments.


*Full disclosure: I worked for AusAID on the design of IndII (I even came up with the name), and collaborate a lot with IndII on a day to day basis in my day job.

What I talk about when I talk about infrastructure

"Infra-"  means "below" and "-structure" means "structure". So when people talk about infrastructure, they are usually talking about the structures that allow things to operate.

Confusingly, people use the word "infrastructure" for all sorts of purposes. IT infrastructure refers to the "combined set of hardware, software, networks, facilities, etc. (including all of the information technology), in order to develop, test, deliver, monitor, control or support IT services". The World Bank has a project where they talk about "judicial infrastructure" being both the physical buildings like courts and offices where the justice system operates, but also the institutions, policies and procedures that allow it to operate. Some people even talk about "emotional infrastructure" of a family or organisation being the systems that allow people to make their feelings known and have them validated. 

When I (and lots of other people) just say "infrastructure" without further clarifying, we are generally talking about the structures that underly the real economy, and allow it to operate smoothly. This sort of infrastructure is usually differentiated along two different axes: hard to soft, and economic to social.

"Hard" infrastructure usually refers to the "crunchy stuff", roads, buildings, physical assets. While "soft" infrastructure refers to institutions, regulations and systems. "Economic*" infrastructure usually refers to things like roads, power systems, ports, while "social" infrastructure refers to schools and education systems, healthcare, sporting facilities, museums and so on.

Below I have sketched out a table showing a very subjective and not-intended-to-be-perfect categorisation of different kinds of infrastructure according to where they sit on the two continua.

Hard vs. soft, and economic vs. social infrastructure

Hard vs. soft, and economic vs. social infrastructure

So, technically, you can call all of this stuff infrastructure. But, this isn't what most people (including me) mean when they say it. When most people talk about infrastructure, they're talking about the upper-left quadrant of my table above; the water and sanitation, power, transportation and telecommunications systems of a country. In general, the further you get away from hard economic infrastructure, the less likely people are to call it infrastructure.

The next table shows what most people mean when they talk about infrastructure, with darker shading denoting the fact that you're likely to get more strange looks if you call it infrastructure.

What most people mean when they talk about infrastructure

What most people mean when they talk about infrastructure

This blog will follow these conventions in most cases, I'll generally talk more about harder economic infrastructure. This is definitely not because I think hard economic infrastructure is more important than other kinds of infrastructure. It's partly because my experience is mostly in these areas, but it's also because sorts of economic tools and techniques I typically use are more easily and less controversially applied to this sort of infrastructure. I'll talk about the difficulty and controversy in future posts, because it's very interesting!

So, that's what I (and lots of other people) talk about when we talk about infrastructure. I hope you find it interesting! 


* The term "economic infrastructure", as opposed to "social infrastructure" is not universally agreed on. Some people refer to power, water, telecoms and transportation systems just as "infrastructure", while schools et al get bundled into "social infrastructure". Some people also use "economic infrastructure" to refer to the economic systems of a country; the central bank, the banking system, etc. Confusing, no?